Futures Contracts

TL;DR

Futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a specific future date. They're primarily used for hedging against price risk or for speculation. Unlike forwards, futures are exchange-traded, offering liquidity and reducing default risk through daily settlement.

1. The Mental Model

Think of a futures contract like a formal, public promise. You're agreeing right now on a price for something you'll deliver or receive later. It's not about paying for it now, but locking in the price for the future transaction.

2. The Core Material

A futures contract is a legally binding agreement to buy or sell a specific quantity of an underlying asset at a predetermined price on a specified date in the future. These contracts are highly standardized, meaning the asset quality, quantity, delivery location, and settlement procedures are all fixed. This standardization allows them to be traded on organized exchanges.

Here's why they're important:

• Standardization: All terms (asset, quantity, quality, delivery date/month) are pre-set by the exchange. This makes them highly liquid and easy to trade.
• Exchange-Traded: Futures are bought and sold on futures exchanges (e.g., CME, ICE). This centralized trading provides transparency and efficiency.
• Clearing House: A critical component is the clearing house, which acts as a counterparty to every trade. It guarantees the performance of the contract, virtually eliminating counterparty risk (the risk that the other party won't fulfill their obligation).
• Margin Accounts: To ensure performance, both buyers (long position) and sellers (short position) must deposit an initial amount of money called initial margin into a margin account.
• Marking-to-Market: Futures contracts are "marked-to-market" daily. This means at the end of each trading day, the contract's value is adjusted to the current market price. Profits are credited to your margin account, and losses are debited. If your account balance falls below a certain level (maintenance margin), you'll receive a margin call and have to deposit more funds.
• Settlement: Most futures contracts are closed out before expiration. If held to expiration, they can be settled either by physical delivery of the underlying asset or by cash settlement, where the difference in value is paid.

Comparing Futures and Forwards

Photo by Ann H on Pexels

It's helpful to contrast futures with forward contracts, which are their over-the-counter (OTC) cousins.

graph TD
    A["Contract Type"] --> B["Futures"];
    A --> C["Forwards"];

    B --> D["Exchange-Traded"];
    B --> E["Standardized Terms"];
    B --> F["Clearing House (Low Counterparty Risk)"];
    B --> G["Marked-to-Market Daily"];
    B --> H["Liquid Secondary Market"];

    C --> I["Over-the-Counter (OTC)"];
    C --> J["Customizable Terms"];
    C --> K["Bilateral Agreement (Higher Counterparty Risk)"];
    C --> L["Settled at Expiration"];
    C --> M["Less Liquid/No Secondary Market"];

Uses of Futures Contracts

Photo by Rafael Minguet Delgado on Pexels

1. Hedging: This is the primary use. Businesses use futures to lock in prices for future purchases or sales of commodities, currencies, or interest rates, thereby reducing price uncertainty.
   • Example: An airline might buy crude oil futures to lock in a price for jet fuel, protecting against rising fuel costs.
   • Example: A farmer might sell wheat futures to lock in a price for their harvest, protecting against falling wheat prices.
2. Speculation: Traders use futures to bet on the direction of future prices. If they expect prices to rise, they buy futures (go long). If they expect prices to fall, they sell futures (go short).
3. Arbitrage: Though less common for individual investors, arbitrageurs look for small price discrepancies between futures and their underlying assets or between different futures contracts to make risk-free profits.

3. Worked Example

Let's say you're a coffee shop owner, and it's January. You know you'll need 1,000 pounds of coffee beans in June. The current spot price for coffee is $1.50/pound, but you're worried prices might go up.

You see a June Coffee Futures contract trading at $1.60/pound for 1,000 pounds. To hedge, you decide to buy one June Coffee Futures contract at $1.60/pound.

• Initial Margin: You deposit, say, $500 into your margin account.
• Daily Settlement:
  • Scenario 1: Coffee prices rise. By May, the June Coffee Futures contract is trading at $1.80/pound. Your contract value has increased. The exchange credits ($1.80 - $1.60) * 1,000 pounds = $200 to your margin account daily (cumulatively).
  • Scenario 2: Coffee prices fall. By May, the June Coffee Futures contract is trading at $1.40/pound. Your contract value has decreased. The exchange debits ($1.40 - $1.60) * 1,000 pounds = -$200 from your margin account daily (cumulatively). You might face a margin call if your balance falls too low.

Let's assume prices rose. By June, the spot price for coffee is $1.85/pound. You don't want physical delivery of coffee through the exchange; you want to buy from your regular supplier.

1. Close out the futures position: You sell one June Coffee Futures contract at the current market price of $1.85/pound.
   • Your initial buy was at $1.60, your final sell was at $1.85.
   • Profit from futures = ($1.85 - $1.60) * 1,000 pounds = $250. This profit is in your margin account.
2. Buy actual coffee: You go to your supplier and buy 1,000 pounds of coffee at the current spot price of $1.85/pound.
   • Cost of actual coffee = $1.85 * 1,000 pounds = $1,850.
3. Net cost of coffee: Your effective cost is the cost of buying the physical coffee minus your profit from the futures contract:
   • $1,850 (physical cost) - $250 (futures profit) = $1,600.

This effectively means you paid $1.60/pound for your coffee, exactly the price you locked in with your futures contract, even though the spot price rose to $1.85. You successfully hedged your price risk.

4. Key Takeaways

• Futures contracts are standardized agreements to trade an asset at a set price on a future date, primarily for hedging or speculation.
• They are traded on organized exchanges and guaranteed by a clearing house, which significantly reduces counterparty risk.
• Marking-to-market means profits and losses are settled daily, requiring margin accounts to cover potential losses.
• Initial and maintenance margins ensure traders have sufficient funds to meet their obligations.

• You can either close out a futures position before expiration or allow it to go to settlement (physical delivery or cash).

• Common Mistakes:

  • Not understanding the daily mark-to-market and potential for margin calls, which can lead to forced liquidation.
  • Confusing futures with forward contracts; futures are standardized and exchange-traded, while forwards are customized and OTC.
  • Overleveraging: Using too much borrowed money with margin accounts, magnifying both potential gains and losses.
  • Trying to perfectly hedge without accounting for basis risk (the risk that the spot price and futures price don't move exactly in tandem).

5. Now Try It

Imagine you're a gold miner. In three months, you expect to extract 100 ounces of gold. The current spot price is $2,000/ounce, but you're worried gold prices might fall. A 3-month gold futures contract for 100 ounces is trading at $1,980/ounce.

1. Decide whether you should buy or sell the futures contract to hedge your price risk.
2. Calculate your profit/loss from the futures contract if, at expiration, the spot price of gold is $1,900/ounce.
3. Determine your effective selling price for your 100 ounces of gold given your futures actions.

Success looks like: Clearly stating your futures action (buy/sell), correctly calculating the futures profit/loss, and arriving at the effective selling price for your gold.