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Futures Definition

 

A futures contract is a standardized contract that calls for the delivery of a specific quantity of a specific product at some time in the future at a predetermined price.
Futures contracts are traded in futures exchanges worldwide and covers a wide range of commodities such as agriculture produce, livestock, energy, metals and financial products such as market indices, interest rates and currencies.

Why Futures?

The primary purpose of the futures market is to allow those who wish to manage price risk (the hedgers) to transfer that risk to those who are willing to take that risk (the speculators) in return for an opportunity to profit.

Hedging

Producers and manufacturers can make use of the futures market to hedge the price risk of commodities that they need to purchase or sell in order to protect their profit margins. Businesses employ a long hedge to lock in the price of a raw material that they wish to purchase some time in the future. To lock in a selling price for a product to be sold in the future, a short hedge is used.

Speculation

Speculators assume the price risk that hedgers try to avoid in return for a possibility of profits. They have no commercial interest in the underlying commodities and are motivated purely by the potential for profits. Although this makes them appear to be mere gamblers, speculators do play an important role in the futures market. Without speculators bridging the gap between buyers and sellers with a commercial interest, the market will be less fluid, less efficient and more volatile.
Futures speculators take up a long futures position when they believe that the price of the underlying will rise. They take up a short futures position when they believe that the price of the underlying will fall.

Example

In March, a speculator bullish on soybeans purchased one May Soybeans futures at $9.60 per bushel. Each Soybeans futures contract represents 5000 bushels and requires an initial margin of $3500. To open the futures position, $3500 is debited from his trading account and held by the exchange clearinghouse.

Come May, the price of soybeans has gone up to $10 per bushel. Since the price has gone up by $0.40 per bushel, the speculator can exit his futures position with a profit of $0.40 x 5000 bushels = $2000.
 
 
Futures Contract Specs
 
Every futures contract is an agreement that represents a specific quantity of the underlying commodity to be delivered.

Unlike options, buyers and sellers of futures contracts are obligated to take or make delivery of the underlying asset on settlement date.

Underlying

Each futures contract represents a specific underlying asset to be delivered on the delivery date. Besides commodities, other instruments such as interest rates, currencies and stock indices are also traded in the futures exchanges.

Exchange

The futures exchange where the futures contract is traded. Some of the world's largest futures exchanges include:

 

     • Chicago Mercantile Exchange (CME)
     • New York Mercantile Exchange (NYMEX)
     • Tokyo Commodity Exchange (TOCOM)
     • Multi-Commodity Exchange (MCX)

 

Symbol

Each futures contract traded in a futures exchange is identified by a unique ticker symbol.

Contract Size

The contract size states the amount and unit of the underlying commodity represented by each futures contract (E.g. 1000 barrels of crude oil or 50 troy ounces of platinum).

Price Quotation

The quoted price of a futures contract is the agreed price (per unit) of the underlying asset that the buyer has to pay to the seller in order to take delivery of the goods. Correspondingly, it is also the price at which the seller must sell the underlying asset to the buyer. Depending on the type of futures contract, the price can be quoted in cents, dollars or even in a foreign currency.

Grade of Deliverable

The grade not only specifies the quality of the underlying but also the manner and the exact place(s) of delivery.

Delivery Date

Each futures contract has a specific delivery date where the seller of the futures contract is required to make delivery of the underlying product being traded and the buyer of the futures contract is required to take delivery.

Last Trading Day

Trading shuts down some time before the delivery date to give the futures contract seller sufficient time to prepare the underlying products for delivery. Futures positions which have not been closed out (offset) before end of the last trading day will have to be settled by making or taking delivery of the underlying product.

Delivery Months

Every futures contract has standardized months at which the underlying can be traded for delivery.
 
 
Futures Exchanges
 
A futures exchange is a financial exchange where futures contracts are traded. Futures exchanges are usually commodity exchanges. This is because all derivatives, including financial derivatives, are often traded at commodity exchanges. The reason for this has to do with the history of the development of these exchanges.

In the 19th century, the first exchanges were opened in Chicago to trade futures contracts on commodities. Exchange traded forward contracts are called futures contracts. Thus, futures trading was synonymous with commodity trading and it has been the case for around a hundred years.

In the 1970s, these commodity exchanges started offering future contracts on other products, such as stocks, options contracts and interest rates. Products such as these are called financial futures. Trading in this new class of futures contracts quickly outgrown the traditional commodities markets. In recognition of this development, commodity exchanges are now generally known as futures exchanges.
 
Major Global Exchanges
 
Today, global exchanges can be found all over the world in both developed and developing countries. The following table lists some of the largest futures exchanges in the world and the principle commodities that are traded at each of these exchanges.
 
 
 
 
Participants in a futures contract are required to post performance bond margins in order to open and maintain a futures position.

Futures margin requirements are set by the exchanges and are typically only 2 to 10 percent of the full value of the futures contract.

Margins are financial guarantees required of both buyers and sellers of futures contracts to ensure that they fulfill their futures contract obligations.

 

Initial Margin
 
Before a futures position can be opened, there must be enough available balance in the futures trader's margin account to meet the initial margin requirement. Upon opening the futures position, an amount equal to the initial margin requirement will be deducted from the trader's margin account and transferred to the exchange's clearing firm. This money is held by the exchange clearinghouse as long as the futures position remains open.

 

Maintenance Margin
 
The maintenance margin is the minimum amount a futures trader is required to maintain in his margin account in order to hold a futures position. The maintenance margin level is usually slightly below the initial margin.

If the balance in the futures trader's margin account falls below the maintenance margin level, he or she will receive a margin call to top up his margin account so as to meet the initial margin requirement.

 

Example
 
Let's assume we have a speculator who has $10000 in his trading account. He decides to buy August Crude Oil at $80 per barrel. Each Crude Oil futures contract represents 1000 barrels and requires an initial margin of $9000 and has a maintenance margin level set at $6500.

Since his account is $10000, which is more than the initial margin requirement, he can therefore open up one August Crude Oil futures position.

One day later, the price of August Crude Oil drops to $78 a barrel. Our speculator has suffered an open position loss of $2000 ($2 x 1000 barrels) and thus his account balance drops to $8000.

Although his balance is now lower than the initial margin requirement, he did not get the margin call as it is still above the maintenance level of $6500.

Unfortunately, on the very next day, the price of August Crude Oil crashed further to $75, leading to an additional $3000 loss on his open Crude Oil position. With only $5000 left in his trading account, which is below the maintenance level of $6500, he received a call from his broker asking him to top up his trading account back to the initial level of $9000 in order to maintain his open Crude Oil position.

This means that if the speculator wishes to stay in the position, he will need to deposit an additional $4000 into his trading account.

Otherwise, if he decides to quit the position, the remaining $5000 in his account will be available to use for trading once again.
 
 
Long Futures Position
 
The long futures position is an unlimited profit, unlimited risk position that can be entered by the futures speculator to profit from a rise in the price of the underlying.

The long futures position is also used when a manufacturer wishes to lock in the price of a raw material that he will require sometime in the future. See long hedge.

To construct a long futures position, the trader must have enough balance in his account to meet the initial margin requirement for each futures contract he wishes to purchase.
 
 

Unlimited Profit Potential

There is no maximum profit for the long futures position. The futures trader stands to profit as long as the underlying futures price goes up.

The formula for calculating profit is given below:

     • Maximum Profit = Unlimited
     • Profit Achieved When Market Price of Futures > Purchase Price of Futures
     • Profit = (Market Price of Futures - Purchase Price of Futures) x Contract Size - Commissions Paid

Unlimited Loss Potential

Large losses can occur for the long futures position if the underlying futures price falls dramatically.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Market Price of Futures < Purchase Price of Futures
     • Loss = (Purchase Price of Futures - Market Price of Futures) x Contract Size + Commissions Paid

Breakeven Point

The underlier price at which break-even is achieved for the long futures position position can be calculated using the following formula.

     • Breakeven Point = Purchase Price of Futures Contract + Commissions Paid

Example

Suppose June Crude Oil futures is trading at $80 and each futures contract covers 1000 barrels of Crude Oil. A futures trader enters a long futures position by buying 1 contract of June Crude Oil futures at $80 a barrel.

SCENARIO #1: JUNE CRUDE OIL FUTURES RISES TO $90

If June Crude Oil futures instead rallies to $90 on delivery date, then the long futures position will gain $10 per barrel. Since the contract size for Crude Oil futures is 1000 barrels, the trader will achieve a profit of $10 x 1000 = $10000.

SCENARIO #2: JUNE CRUDE OIL FUTURES DROPS TO $70

If June Crude Oil futures is trading at $70 on delivery date, then the long futures position will suffer a loss of $10 x 1000 barrel = $10000 in value.

Daily Mark-to-Market & Margin Requirement

The value of a long futures position is marked-to-market daily. Gains are credited and losses are debited from the future trader's account at the end of each trading day.

If the losses result in margin account balance falling below the required maintenance level, a margin call will be issued by the broker to the futures trader to top up his or her account in order for the futures position to remain open.

Synthetic Long Futures

An equivalent position known as a synthetic long futures position can be constructed using only options.
 
 
Short Futures Position

The short futures position is an unlimited profit, unlimited risk position that can be entered by the futures speculator to profit from a fall in the price of the underlying.

The short futures position is also used by a producer to lock in a price of a commodity that he is going to sell in the future. See short hedge.

To create a short futures position, the trader must have enough balance in his account to meet the initial margin requirement for each futures contract he wishes to sell.
 

Unlimited Profit Potential

There is no maximum profit for the short futures position. The futures trader stands to profit as long as the underlying asset price goes down.

The formula for calculating profit is given below:.

     • Maximum Profit = Unlimited
     • Profit Achieved When Market Price of Futures < Selling Price of Futures
     • Profit = (Selling Price of Futures - Market Price of Futures ) x Contract Size - Commissions Paid

Unlimited Loss Potential

Large losses can occur for the long futures position if the underlying futures price falls dramatically.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Market Price of Futures > Selling Price of Futures
     • Loss = (Market Price of Futures - Selling Price of Futures) x Contract Size + Commissions Paid

Breakeven Point

The underlier price at which break-even is achieved for the long futures position position can be calculated using the following formula.

     • Breakeven Point = Selling Price of Futures Contract - Commissions Paid

Example

Suppose June Crude Oil futures is trading at $70 and each futures contract covers 1000 barrels of Crude Oil. A futures trader enters a short futures position by selling 1 contract of June Crude Oil futures at $70 a barrel .

SCENARIO #1: JUNE CRUDE OIL FUTURES DROPS TO $70

If June Crude Oil futures is trading at $70 on delivery date, then the short futures position will gain $10 per barrel. Since the contract size for Crude Oil futures is 1000 barrels, the trader will net a profit of $10 x 1000 = $10000.

SCENARIO #2: JUNE CRUDE OIL FUTURES RISES TO $90

If June Crude Oil futures instead rallies to $90 on delivery date, then the short futures position will suffer a loss of $10 x 1000 barrel = $10000 in value.

Daily Mark-to-Market & Margin Requirement

The value of a short futures position is marked-to-market daily. Gains are credited and losses are debited from the future trader's account at the end of each trading day.

If the losses result in margin account balance falling below the required maintenance level, a margin call will be issued by the broker to the futures trader to top up his or her account in order for the futures position to remain open

Synthetic Short Futures

An equivalent position known as a synthetic short futures position can be constructed using only options.
 
 
Long Hedge

The long hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or commodity to be purchased some time in the future. Hence, the long hedge is also known as input hedge.

The long hedge involves taking up a long futures position. Should the underlying commodity price rise, the gain in the value of the long futures position will be able to offset the increase in purchasing costs.

Example

In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in September. Let's assume that the total amount of wheat needed to produce the flour is 50000 bushels. Based on the agreed selling price for the flour, the flour maker calculated that he must purchase wheat at $7.00/bu or less in order to breakeven.

At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat futures are trading at $6.70 per bushel, and the flour maker wishes to lock in this purchase price. To do this, he enters a long hedge by buying some September Wheat futures.

With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures contracts to hedge his projected 50000 bushels requirement.

In August, the manufacturing process begins and the flour maker need to purchase his wheat supply from the local elevator. However, the price of wheat have since gone up and at the local elevator, the price has risen to $7.20 per bushel. Correspondingly, prices of September Wheat futures have also risen and are now trading at $7.27 per bushel.

Loss in Cash Market…

Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose $0.20/bu. At 50000 bushels, he will lose $10000 in the cash market.

So for all his efforts, the flour maker might have ended up with a loss of $10000.

... is Offset by Gain in Futures Market.

Fortunately, he had hedge his input with a long position in September Wheat futures which have since gained in value.

Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts = $335000

Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts = $363500

Net Gain in Futures Market = $363500 - $335000 = $28500

Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500

Hence, with the long hedge in place, the flour maker can still manage to make a profit of $18500 despite rising Wheat prices.

Basis Risk

The long hedge is not perfect. In the above example, while cash prices have risen by $0.60/bu, futures prices have only gone up by $0.57/bu and so the long futures position have only managed to offset 95% of the rise in price. This is due to the strengthening of the basis.
 

The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis once a hedge is in place.
 
 
Short Hedge

The short hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or commodity to be delivered some time in the future. Hence, the short hedge is also known as output hedge.

The short hedge involves taking up a short futures position while owning the underlying product or commodity to be delivered. Should the underlying commodity price fall, the gain in the value of the short futures position will be able to offset the drop in revenue from the sale of the underlying.

Example

In March, a wheat farmer is planning to plant 100000 bushels of wheat, which will be ready for harvesting by late August and delivery in September. The farmer knows from past years that the total cost of planting and harvesting the crops is about $6.30 per bushel.

At that time, September Wheat futures are trading at $6.70 per bushel, and the wheat farmer wishes to lock in this selling price. To do this, he enters a short hedge by selling some September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to sell 20 futures contracts to hedge his projected 100000 bushels production.

By mid-August, his wheat crops are ready for harvesting. However, the price of wheat have since fallen and at the local elevator, the price has dropped to $6.20 per bushel. Correspondingly, prices of September Wheat futures have also fallen and are now trading at $6.33 per bushel.

Loss in Cash Market…

Selling his harvest of 100000 bushels of wheat at the local elevator yields $6.20/bu x 100000 bushels = $620000.

But the cost of growing the crops is $6.30/bu x 100000 bushels = $630000

Hence, his net profit from the farming business = Revenue Yield - Cost of Growing Crops = $620000 - $630000 = -$10000

For all his efforts, the wheat farmer might have ended up with a loss of $10000.

... is Offset by Gain in Futures Market.

Fortunately, he had hedge his output with a short position in September Wheat futures which have since gained in value.

Value of Wheat futures Sold in March = $6.70 x 20 contracts x 5000 bushels = $670000

Value of Wheat futures Purchased in August = $6.33 x 20 contracts x 5000 bushels = $633000

Net Gain in Futures Market = $670000 - $633000 = $37000

Overall profit = Gain in Futures Market - Loss in Cash Market = $37000 - $10000 = $27000

Hence, with the short hedge in place, the farmer can still manage to make a profit of $27000 despite falling Wheat prices.

Basis Risk

The short hedge is not perfect. In the above example, while cash prices have fallen by $0.40/bu, futures prices have only dropped by $0.37/bu and so the short futures position have only managed to offset 92.5% of the drop in price. This is due to the weakening of the basis.
 

The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis once a hedge is in place.
 
 
Futures Basis

The basis reflects the relationship between cash price and futures price. (In futures trading, the term "cash" refers to the underlying product). The basis is obtained by subtracting the futures price from the cash price.

The basis can be a positive or negative number. A positive basis is said to be "over" as the cash price is higher than the futures price. A negative basis is said to be "under" as the cash price is lower than the futures price.
 
 

Strong  or Weak Basis

The basis changes from time to time. If the basis gains in value (say from -4 to -1), we say the basis has strengthened. On the other hand, if basis drops in value (say from 8 to 2), we say the basis has weakened.

Short term demand and supply situations are generally the main factors responsible for the change in the basis. If demand is strong and the available supply small, cash prices could rise relative to futures price, causing the basis to strengthen. On the other hand, if the demand is weak and a large supply is available, cash prices could fall relative to the futures price, causing the basis to weaken.
However, although the basis can and does fluctuate, it is still generally less volatile than either the cash or futures price.

Basis Risk

Basis risk is the chance that the basis will have strengthened or weakened from the time the hedge is implemented to the time when the hedge is removed. Hedgers are exposed to basis risk and are said to have a position in the basis.

Long Basis Position

A long basis position stand to gain from a strengthening basis. Short hedges have a long basis position.

Short Basis Position

A short basis position stand to gain from a weakening basis. Long hedges have a short basis position.

long futures position can be constructed using only options.