If an exchange trader simply buys shares, he makes a regular transaction: he pays money and immediately receives the desired product. There are other types of trading operations, when the seller and the buyer agree in advance on the prices for supplies, which will not be carried out immediately, but in a very distant future. One of such transactions is the conclusion of a futures contract.
What is a futures contract?
A futures contract (futures) is a derivative financial instrument traded on specialized exchanges. This is a kind of contract, according to which the seller makes an obligation to deliver the underlying asset, and the buyer undertakes to pay for it in the future at the price that was determined at the time of the transaction.
The futures markets started working in the middle of the 19th century. For about a century, futures trading was carried out, as a rule, in precious metals and agricultural products. Only in the second half of the last century, stock indices, financial instruments, mortgage-backed securities, and oil products entered circulation. The emergence of futures gave market participants confidence that the obligations under the transaction would be fulfilled regardless of changes in market prices. Forming future prices, futures contracts to a certain extent set the pace of economic development, which largely determines their value.
The assets underlying the futures contract have been brought to the standard form. Delivery dates and characteristics are predefined. The specification of a futures contract indicates the place of delivery, for example, a depository for securities or a warehouse for a commodity, as well as other details of the transaction (quantity, quality, labeling and packaging). Since futures are traded on an organized exchange, it is easy for buyers and sellers to find each other. The parties to the contract are liable to the exchange until the futures are settled. If, after the expiration of the contract, the seller will not have the desired product, the exchange has the right to fine him.
The world's leading futures exchanges:
- New York Mercantile Exchange;
- Chicago Mercantile Exchange;
- London Stock Exchange of Financial Futures and Options;
- London Metal Exchange;
- Australian Stock Exchange;
- Singapore Exchange.
Categories and types of futures contracts
In accordance with the assets for which the transaction is concluded, the following main categories of futures contracts are distinguished:
- grocery;
- agricultural;
- for energy resources;
- for precious metals;
- currency;
- financial.
Futures contracts can be deliverable, when the underlying asset is required to be provided physically, as well as settlement, when after the expiration of the contract, mutual settlements between the parties to the transaction take place and the price difference is paid. Currently, most futures contracts are settlement, that is, they do not provide for the supply of goods in the physical sense. In general, when applied to futures, the term “commodity” has a broad definition. It can mean a financial instrument and even a stock quote.
Futures contract specification
The specification for a futures contract specifies:
- name of the contract;
- type of contract;
- the amount of the underlying asset stipulated by the contract;
- the date of delivery of the asset;
- the minimum amount of price change;
- the cost of the minimum step.
Operations with futures
The operation to buy a futures is called opening a long position, and the operation to sell - opening a short position. Standardization of contracts allows buying and selling within the same exchange to cover each other. To open a position, you need to post an initial collateral, also called collateral. The recalculation of mutual obligations usually occurs after each day. The difference between the price of opening and closing a position goes to the investor's account or is debited. Since the difference was previously calculated, at the beginning of the next trading day, the opening of a position in a futures contract is taken into account at the closing price of the previous trading session.
As with any transaction, there are two parties to a futures contract (seller and buyer). The key feature of a futures contract is “commitment”. If an option gives only the right, but does not oblige, to purchase an asset at the expiration of the contract, then stricter rules apply to the futures. A futures transaction imposes certain obligations on both parties to the financial agreement.
Buying and selling futures contracts on the exchange is carried out in portions of the asset (goods). Such portions are called lots. This is the difference between a futures and a forward transaction, where the quantity of goods can be any and is determined by an agreement between the parties.
The lifetime of a futures contract is limited. With the onset of the last day of trading, it is no longer possible to conclude futures transactions on that date. Then the exchange sets the next term, after which a new futures contract begins to be traded.
Functions and parameters of a futures contract
Futures contract functions:
- determination of the fair price for a financial asset (raw materials, commodities, currency);
- financial risk insurance (hedging);
- speculative transactions with the aim of obtaining benefits;
- study of opinions on price dynamics.
Futures contract parameters:
- instrument (subject of the contract);
- date of execution;
- the exchange where the contract is sold;
- unit of measure of the asset;
- the size of the deposit margin (the amount contributed to cover possible losses).
Features of futures transactions
The value of a futures contract is linked to an actual commodity or financial instrument through the terms of a separate transaction. When purchasing a futures contract, the participants in the transaction should remember that neither the risk nor the potential profit is limited by anything.
The financial result of a futures transaction is equal to the value of the variation margin, which is calculated daily on all trading days and is calculated as profit or loss after opening or closing a contract.
The deposit margin serves as a collateral for a futures transaction. It is charged from both the seller and the buyer and is a refundable insurance premium that the exchange takes into account when opening a position under a contract. Typically, the contribution is a few percent of the current market value of the underlying asset. When calculating collateral, the exchange takes into account statistical data and takes into account the maximum deviations in the value of an asset during the day. Sometimes brokers insist on placing a margin in a larger amount than is required by the calculations.
After the conclusion of the futures contract, the links between the seller and the buyer are terminated, since the exchange is now the party to the transaction. Therefore, the margin is designed to protect the clearinghouse of the exchange from risks associated with a breach of contractual obligations by one of the clients. In the context of constantly changing market conditions, this moment of the transaction becomes especially important.
When the futures expire, the contract is executed, that is, the delivery procedure is executed or the price difference is paid. The contract is always executed at the price fixed on the day of its conclusion. The underlying asset is supplied through the very exchange where the contract is traded.
The fact that the price of an asset is fixed at the conclusion of the contract allows the futures to be an instrument for insuring currency risks. This hedging is widespread in the business world. Representatives of the real sector of the economy very often turn to transactions of this kind: farmers, equipment manufacturers. They pursue the goal of reducing risk or finding a source of large (albeit risky) profits. At their core, futures markets are sources of risk, where those who are willing to take risks for a fee are located. When buying a futures contract, the price risk is actually shifted onto the shoulders of the other party. For this reason, participants in futures trading are usually conventionally divided into “speculators” and “hedgers”. The former want to get the maximum profit, the latter want to minimize the risk. A futures contract concluded for a certain period can be viewed as a dispute, the subject of which can be almost any object, including stock indices.
According to Russian law, all claims arising from transactions with futures contracts are subject to judicial protection, but only if the parties to the transaction comply with the conditions specified by law. Futures are considered liquid but risky and not very stable transactions. Novice investors and stock speculators need to be properly prepared to deal with such a financial derivative.
