Financial Futures are a very important instrument in markets. We will discuss what they are, how they work, and the markets we can trade with futures.
- Introduction to Financial Futures
- Types of Futures
- How Financial Futures work
- Main characteristics of Financial Futures
- Uses of Financial Futures
Introduction to Financial Futures
Futures are financial derivatives that allow us to buy or sell a particular asset at a future date and at a predetermined price. That asset can be financial, such as a stock market index or a bond, or it can be a real asset, such as gold or oil.
If we buy a futures contract, we can lock in the purchase at that price, without having to make all the payment in advance.
If we sell a futures contract, we can lock in the sale at that price, without having to deliver that asset right away. This means we can sell something we do not own yet.
Futures allow buyers and sellers to agree on a transaction prices and delivery date in the future. Futures make it possible to reduce risks and uncertainty on both sides of the transaction.
An oil company may be interested in locking in the price at which it will sell its barrels of oil next year, since that allows the company to plan and make investments with more guarantees.
At the same time, an airline may want to buy barrels of oil in advance, to hedge the risk of fuel prices skyrocketing and having to raise the price of tickets, which could lead to a loss of customers.
Financial futures are also ideal for those who want to speculate on the price direction in which an asset will move, since futures make it possible to buy and sell large amounts with very little money.
When we buy or sell a futures contract, we commit to buying or selling the underlying asset in the future. However, we also have the option to close our position before that happens. This can be done by simply executing an opposite transaction.
That is best understood with an example. Let us use oil for this:
If we had bought three oil futures contracts thinking that oil prices would increase, and not with the intention of buying those barrels, we have the option to sell three contracts before the expiration date of the futures.
Because all contracts are equal, this sale would cancel out our position entirely. We would not have to buy or sell any barrels of oil. We just wanted to speculate on whether the price of crude oil would rise or fall, and futures made it possible.
But financial futures are also used by many large investors and corporations to reduce risks. We can sell what we do have, with the aim of minimizing losses in case the price of that asset collapses We can also buy today what we will need tomorrow.
Futures were invented in Holland in the 17th century, the cradle of modern financial capitalism, and soon arrived in Britain and Japan. Originally, they were used for real assets, such as rice or wheat. Nowadays, there are financial futures of many kinds, including for Bitcoin.
Financial futures are traded on stock exchanges, just like stocks. As a result, they are highly regulated markets.
Types of Futures
These are the main types of financial futures that exist:
Stock market index futures
Futures on stock market indices are one of the most famous types of all. Their underlying is a stock index. Most major indices have futures associated with them, which allow investors to buy or sell the entire index at a future date and predetermined price,
For example, there are futures for indices such as the S&P 500, the Nasdaq 100, the German DAX or the Spanish IBEX 35.
If we buy an S&P 500 futures contract, we are committing ourselves to buying the entire index at a particular date in the future. If we just want to bet on the future price of the index, we can close our position before that date by selling an S&P 500 futures contract. This would close out our position.
If our intention is really to buy the entire index, we can leave our position open, and simply make the payment when the futures contract expires. In exchange for our payment, we will receive the 500 stocks in the index.
Some major stock market indices even have different futures contracts available, with different face values.
For example, when it comes to the German stock index DAX, we have the DAX futures and the Mini-DAX futures. DAX futures have a nominal value of €25 per point, while the nominal value of Mini-DAX futures is €5.
If we take into account that the DAX may easily by trading at around 15,000 points, we are talking about contracts with nominal values of €375,000 and €75,000, respectively.
Contracts with different nominal values exist to accommodate the needs of investors of all sizes.
The first futures contracts created were for commodities, especially agricultural products. They allowed farmers and wholesalers to set the price at which they were going to buy and sell those goods in the future.
As a result, farmers locked in the sale price and eliminated the risk of their production falling in price. Simultaneously, buyers secured the purchase price, eliminating the risk of an increase in prices.
Nowadays, we trade many types of commodities for which financial futures are available.
We still find agricultural products, such as rice, corn or sugar. Energy products such as oil or natural gas. Industrial metals, such as copper or steel. Precious metals such as gold, silver, platinum or palladium. And many more.
Something we should highlight about commodity futures is that they are the main way in which these assets are traded. Consequently, the price of the futures indicates the price for that asset.
For example, the price of gold is set by the price at which gold futures are traded around the world. The main markets for gold are in London, New York and Shanghai.
Bonds and interest rates futures
Government bond futures and interest rate futures are used by speculators, investors and financial institutions in general, to bet on the future direction of interest rates.
Bond futures refer to the major countries in the world. And they are available for bonds with different maturities. For example, there are four types of German bond futures, which allow us to bet on the interest rates of German bonds with maturities of 2, 5, 10 and 30 years.
As for interest rate futures, they refer to short-term interest rates. They allow investors and speculators to bet on the future level of the Fed Funds rate or the Euribor index.
Currency futures allow us to buy and sell currencies at a specific exchange rate at a future date. For example, we can commit to buying a million US Dollars, paying in Euros, at an exchange rate of 1.20 US Dollars per Euro within 2 months.
As you can imagine, just because we commit to buying that amount does not mean we have to. We can close out our position at any time by doing an opposite trade.
It should be noted that currency futures are not the main derivative used for buying and selling currencies in the future. Large institutions use instruments such as FX Forwards and FX Swaps to make these types of transactions because they need additional flexibility.
However, currency futures allow small investors to make bets on the exchange rates of some currencies.
Cryptocurrency futures are fairly new, since cryptocurrencies have been in existence since 2009, and futures were only created when there was enough interest from the investing community.
Cryptocurrency futures allow us to buy and sell a certain amount of crypto at a future date.
The first contracts available were for Bitcoin. And then came a futures contract for Ethereum. If this asset class continues to grow in the future, we will probably end up seeing futures contracts for additional cryptocurrencies.
How Financial Futures work
When we buy or sell financial futures, we must put some money in the form of a down payment. That money is known as margin. It is there to guarantee that we will make good on the promise to pay a certain amount of money if futures prices move against us.
The margin covers a small percentage of the total nominal value of what we are buying or selling. In general, the higher the volatility in the price of the futures, the more margin we will have to post. This is because the probability of losses is also higher.
For example, gold futures in Chicago are for 100 ounces per contract. If the price of gold trades at $1,800, each futures contract commits us to buying or selling $180,000 worth of gold. For that futures contract, the margin is $9,000, around 5%.
This means that this futures allows us to buy $180,000 of gold with only $9,000 dollars as down payment. This is a leveraged trade. And the margin only covers 5% of our total position.
If the price of gold fell by 5%, we would lose all our money, and our position would be automatically closed out by our broker, unless we were able to put additional money in the form of margin.
At the same time, if the price of gold increased by 5%, we would have been able to double our initial investment. And we could close our position at any time.
Financial futures usually trade Monday through Friday for 23 hours a day. In this sense, they allow us to buy or sell an asset at virtually any time.
The time when futures markets do not trade is known as the daily close. Everyone’s positions are evaluated. If the price has moved against us, we will see our margin decrease, and we may have to put more money in.
If the price has moved in our favor, our margin will increase. We will be able to withdraw some gains and keep our position open. Or we could withdraw everything by closing our position.
For example, if the price of gold has risen to $1,850, we would have made a profit of $5,000 ($50 profit per ounce on a 100-ounce contract). Our previous margin of $9,000 would have grown to $14,000.
Main characteristics of Financial Futures
Let us analyze the main characteristics of financial futures:
We have discussed the main types of financial futures in another section. The most important characteristic of any futures contract is its underlying asset. In other words: what are we buying or selling?
After all, we could have two financial futures, one for US Treasury bonds and one for Bitcoin, and call them both futures. But their potential for profits and losses as well as their volatility would be wildly different.
We must be able to answer the question: what are we trading with this futures?
Nominal or face value
We have already seen that futures can be bought and sold on margin, which is usually a small percentage of the total value of the transaction. It is not uncommon for the margin to be only 4-5% of the entire nominal amount we are trading.
However, we must always know the nominal value of the futures we are trading. Nominal values can be very large.
For example, with only $9,000 down payment we can buy $180,000 worth of gold. That is, putting only 5% down. If the price moves 5% against us, we will lose everything. But even if it only moves 1% against, we will lose 20% of our margin.
Financial futures have aa expiration date. When that date arrives, all open positions will become effective.
This means that, if our gold futures is still open on the expiration date, we will have to buy those 100 ounces of gold, and pay $180,000 for them. Margin money is only useful while the futures is still trading.
Once the futures contract expires, we have to make full payment if we are buying, or make delivery of the goods if we are selling.
If we are not interested in effectively buying or selling the underlying asset but want to continue trading it in the form of futures contracts, we must close our current position, and open a new position in a futures contract of the same underlying with a later expiration date.
For most underlying assets, there are futures contracts expiring every 3 months. As a result, we may need to close out a position and open a new one four times a year. This process is known as “rolling” our futures positions.
A few futures contracts have monthly expiration. Simply make sure you know the expiration date of your contracts before trading them and after you have opened your positions.
When the expiration date is reached, we must make the actual purchase or sale, but how that is done depends on the type of settlement. There are two different types of settlement: physical delivery or cash settled.
Physical delivery means that the transaction takes place. If we had committed to buying 100 ounces of gold, then we will have to pay for them, and those ounces will be delivered to us.
Physical delivery is not exclusive to commodities. When we talk about stock market indices or government bonds, physical delivery means that we effectively buy and take possession of all the stocks in the index or the corresponding government bond. And we will have to pay for that.
However, there are also futures contracts with cash settlement. In that case, there is no delivery. The margin amount is adjusted for everyone according to the price of the underlying, and all positions are closed. As a result, we are not forced to buy or sell anything.
Open interest is a very important piece of information when analyzing a futures contract. It tells us the volume of contracts that are open at any given time. For example, if the open interest is 50,000, there are 50,000 contracts on the long side, from people who have bought them, and 50,000 contracts on the short side, from people who have sold them.
Realize that there is no finite number of contracts. New contracts can be created at any time. That happens when we find someone taking the opposite side of our trade.
Contracts can also be eliminated at any time, by closing our position. We would find someone taking the other side of the trade.
Open interest gives us information about the existing liquidity in the market, and the interest of people in buying and selling that futures contract. The higher the open interest, the more liquidity.
If you look at futures contracts with very long expiration dates, you will see that the open interest is practically 0. This means there is almost no liquidity, so we may not be able to trade those contracts.
Similarly, as a futures contract approaches its expiration date, you will see how its open interest begins to decline. This is because many people do not want to have to execute the contract. As a result, they will close out their positions in this contract and open a new position in another contract.
Uses of Financial Futures
Although they tend to enjoy a very bad reputation, financial futures are used by many different economic agents and play an important role in both financial markets and the economy. These are the main uses of financial futures:
Financial futures are ideal instruments for those who want to trade the financial markets short-term. These are financial institutions or individuals seeking to make a profit.
This is because financial futures usually have very good liquidity, trade for very long hours, and allow for leverage, increasing the potential for gains.
If you are interested in trading futures, bear in mind that they are risky instruments.
For those who wish to speculate on what will happen in the next few weeks, months or even years, futures can also be a great tool. They can be used as an alternative form of investment.
If we think the price of oil or the S&P 500 is going to rise over the next 6 months, we can buy a futures contract that expires in about 6 months and forget about it. We do not need to actually buy the 500 companies in the index or a bunch of barrels of oil.
Because there may be significant price fluctuations, we need to make sure we always have enough margin. Remember we can close out our position easily at any time.
Reduce or hedge financial risks
Financial futures allow investors and financial institutions to reduce risks. This is because these institutions are already exposed to a series of risks, and futures contracts offer the possibility of taking positions with the opposite risk profile.
For example, if a fund manager who invests in US stocks believes there may be a correction in the stock market, they have several options to hedge against that risk. One option would be to simply sell everything they own and keep cash in the portfolio. But this may either be impossible or not feasible.
On the other hand, they could easily sell S&P 500 futures. If the stock market does go down, the fund’s stocks would go down with it. But similar profits would be made by having sold the S&P 500 futures, making up for the losses in the stocks.
As a result, financial futures allowed us to reduce our risk. The same thing can be done if we own a lot of bonds but expect interest rates to go up. We would simply sell government bond futures.
Reduce or hedge commercial risks
The other way futures reduce risks is when we talk about producers and consumers of raw materials.
The producer may be interested in locking in the selling price of their production next year. This would make it possible to properly plan their operations. And that statement is valid regardless of whether they sell oil, gold, silver, wheat or coffee.
On the other hand, consumers of raw materials may want to secure the purchase price for next year. They can also plan better if they know their costs in advance. Think of an airline selling tickets a year in advance, or a car manufacturer selling cars that have not been built yet.
Financial futures, being derivative products, may have a very bad reputation. However, they were created to meet a need in the marketplace. And they allowed the economy to function better.
It is true that the financial aspect is now more important. But remember that financial futures can also be used to reduce risks on the side of financial institutions.
When it comes to price discovery, futures allow us to know at what prices many assets are trading. Not only for immediate delivery but also in the future. For example, we can know the price of oil if we want to buy it in 2 months or in 5 years.
For those risk-seekers who want to speculate or trade, futures are an ideal instrument to transact. But they come with considerable risk. Do your due diligence and always know your downside.
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