What is a futures contract?
A futures contract is a legally binding agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset.
What is a futures exchange?
A futures exchange is a central marketplace with established rules and regulations where buyers and sellers meet to trade futures and options contracts. An exchange can include a physical structure and/or an electronic marketplace.
Can you provide examples of futures trading?
A futures contract may be bought (long) in anticipation of the value of the contract rising in price. In this scenario, the objective is to sell the contract at a higher price than which it was purchased, profiting from the difference.
A futures contract may also be sold (short) in anticipation of the value of the underlying contract declining in price. The objective is to buy the contract at a lower price than which it was sold, profiting from the difference.
Do futures contracts have provisions to take delivery of the underlying product?
Many futures contracts contemplate that actual delivery of the commodity (i.e., gold, silver, etc.) can take place to fulfill the contract. However, some futures contracts require cash settlement instead of delivery, and most contracts are liquidated before the delivery date. To offset a long position, an investor would sell the same futures contract. Conversely, to offset a short futures position, an investor would buy the same futures contract.
Can you explain margin on futures?
Margin (or performance bond) is the amount of money or collateral deposited by a customer with his broker, by a broker with a clearing member, or by a clearing member with a clearing organization. Initial margin is the amount of margin required by the broker when a futures position is opened and maintenance margin is an amount that must be maintained on deposit at all times. If the equity in a customer's account drops to or below the level of maintenance margin because of adverse price movement, the broker must issue a margin call to restore the customer's equity to the initial level.
For example, if a customer purchased an XYZ futures contract for $1,300 per unit, he would have to deposit "initial margin." This contract controls 100 units of XYZ. Without margin, one would have to pay: $1,300 x 100 units = $130,000 to enter the trade. However, an exchange only requires a very small percentage of this deposit referred to as initial margin. Contracts may have this margin stated as a percentage, say 5% of the underlying value, or a specified dollar amount, for example $5,670. Either way, this amount is initially required to purchase a futures contract. Given the above information, one can begin to appreciate the leverage inherent in a futures contract. For a deposit of $5,670, an investor controls $130,000 worth of XYZ. Of course, leverage works both ways - profits are greater as prices move in the investor's favor, as are losses when prices move against the investor.
What are the differences between speculators and hedgers?
Speculators are market participants who attempt to profit from buying and selling futures contracts and/or options on futures contracts by anticipating future price movements. Speculators provide liquidity to the marketplace because they are willing to take the other side of various trades.
Hedgers are market participants attempting to offset market and/or investment risk. For example, a jewelry manufacturer may need a certain amount of gold in the future and believes the price of gold will rise significantly in the future. Such a manufacturer may find the current price of a gold futures contract to be more beneficial. As such, he can elect to lock in the price of gold today by purchasing a gold futures contract.
Of course, the price of gold could decline in the future resulting in the effective purchase price for the manufacturer being higher if he elected to enter into a hedge transaction by purchasing a futures contract. Nonetheless, the risk of purchasing gold at a much higher price can be reduced by entering into a hedge transaction.
Please explain the concept of price discovery?
Futures markets tend to reveal information about the expected prices of underlying products in the future. In buying or selling a futures contract, an investor agrees to receive or deliver a specific commodity at a specific time in the future at a price determined today. Given this information, one can see how a relationship exists between the value of a futures contract and the price that investors anticipate the commodity may be at in the future. Of course, the market participants may be incorrect about anticipated future prices.
To fully understand the value of a futures contract however, it is necessary to also understand the "cost of carry" associated with such an instrument. For example, if a hedger sold a gold futures contract and intended to make delivery on that contract in the future (perhaps a gold mining company), the hedger would have to pay to transport the gold and store the gold. These costs of "carrying" contribute to the value of the futures contract as will the cost of money (interest rates).
What is "convergence" as it relates to futures contracts?
Convergence refers to the fact that as time to expiration of a futures contract approaches, the value of the futures contract must approach the value of the cash (or "spot") market. The difference between the spot price and the futures price is referred to as the "basis." The basis declines over time until, at expiration of the futures contract, the values converge and become equal - at this point the futures contract essentially is the same as the spot. Of course, the futures contract will no longer trade and investors should understand the last trading date for the contracts they may be trading.