THE FUTURES MARKET
What we know as the futures market of today came from some humble beginnings. Trading in futures originated in Japan during the 18th century and was primarily used for the trading of rice and silk. It wasn't until the 1850s that the U.S. started using futures markets to buy and sell commodities such as cotton, corn and wheat.
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something, for a set price, that is not deliverable until a future date. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities. Traders in the futures market primarily enter into futures contracts to hedge risk or speculate rather than exchange physical goods. The cash (spot) market is where producers exchange physical goods. Futures are used as financial instruments which to eventually tend to parralell the price movement of the underlying cash market.
The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky, and complex by nature, but it can be understood if we break down how it functions.
While futures are not for the risk-averse, they are useful for a wide range of people. A common denominator among all futures contracts, is the need for hedging the underlying commodity.
Before the North American futures market originated some 150 years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed, and unpurchased crops were left to rot in the streets. Conversely, when a given commodity, such as grain, was out of season, the goods made from it became very expensive because the crop was no longer available.
In the mid-19th century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The forward delivery contracts were the forerunners to today's futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season. An important distinction between forward contracts and futures contracts is contract spefication. Specifications for all futures contracts for a particular commodity are the same, except for price. Forward contracts could have varying specifications, such as size, quality, and delivery date.
As the agriculture commodities dominated the futures markets for over 100 years, financial contracts, such as foreign currencies, treasuries, and stock indices were introduced in the 1970's and 1980's, and have dominated the futures industry ever since.
HOW IT WORKS
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity
A futures contract is an agreement between two parties: a short position, the party who agrees to deliver a commodity, and a long position, the party who agrees to receive a commodity.
In every futures contract, everything is specified. The quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The price of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future.
Profit And Loss - Open Trade Equity
The profits and losses of a futures depend on the daily movements of the market for that contract and is calculated on a daily basis. For example, say the futures contracts for wheat increases 10 cents per bushel the day after a trade is made. (Each cent change is equal to $50.00).
On the day the change occurs, the seller's account is debited $500 (10 cent x $50), and the buyers account is credited $500. As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled.
A futures contract is really more like a financial position. You can see that the two parties in the wheat futures contract discussed above could be speculators or hedgers. If a speculator, the profit or loss is treated as a short-term capital gain. If a hedger, the gain or loss would offset the change in value of the underlying physical commodity.
Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.
The holders of the long position in futures contracts (the buyers of the commodity), are trying to secure as low a price as possible. The short holders of the contract (the sellers of the commodity) will want to secure as high a price as possible. The futures contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold.
Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits. The speculator is vitally important as they help provide the liquidity that the hedger needs.
In the futures market, a speculator buying a contract low in order to sell high in the future might be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future.
Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.
The United States' futures market is regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the U.S. government. The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.
A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange. It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the CFTC.
In the unfortunate event of conflict or illegal loss, you can look to the NFA for arbitration and appeal to the CFTC for reparations. Know your rights as an investor!
MARGINS AND LEVERAGE
In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities. In the futures market, margin refers to the initial deposit of good faith made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.
When you initiate a futures position, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.
The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished back to the initial margin excess. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.
Let's say that you had to deposit an initial margin of $1,000 on a contract and the maintenance margin level is $500. A series of losses dropped the value of your account to $400. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional $600 to bring the account back up to the initial margin level of $1,000.
Word to the wise: when a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf.
The Double-Edged Sword
In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.
Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000 pounds of coffee valued at $50,000, which would be considered highly leveraged investments.
You already know that the futures market can be extremely risky, and therefore not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: great profits or even greater losses.
Due to leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy a futures contract with a margin deposit of $10,000, for an index currently standing at 1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss, $250 will be gained or lost.
If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor earned a profit of $16,250 (65 points x $250); a profit of 162%!
On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250--a huge amount compared to the initial margin deposit made to obtain the contract. This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that a small change of 5% to the index could result in such a large profit or loss to the investor (sometimes even more than the initial investment made) is the risky arithmetic of leverage. Consequently, while the value of a commodity or a financial instrument may not exhibit very much price volatility, the same percentage gains and losses are much more dramatic in futures contracts due to low margins and high leverage.