A futures contract or ‘futures’ is a standardised (in quantity, quality, delivery time and location) agreement to buy (or sell) a commodity, bond, currency or index on a future date at a specified price. Future contracts are transferable, exchanged traded derivatives and provide for either physical delivery or cash settlementshow more
Dating back from the modest beginnings of the first modern organised futures exchange at the Dojima Rice Exchange in Osaka, Japan in 1710, futures trading is now a 24-hour a day, seven day a week financial marketplace with annual trading volume exceeding 25.22 billion contracts (in 2016) and average trading volume exceeding 16.3 million contracts (April 2017). The most liquid futures contracts traded globally are the S&P500, crude oil, gold, Eurodollar and 10-Year Treasury Notes.
Futures market participants include hedgers and speculators. For farmers, importers and exporters who are typically hedgers, buying and selling futures contracts provides an effective and efficient mechanism for management of price fluctuation risk. Alternatively, speculators are traders and investors who buy and sell futures contracts forecasting future price movements in anticipation of trading profits.
While the first modern standardised futures contract was traded at the end of the 17th century at the Dojima Rice Exchange in Japan, western commodity futures markets reportedly started trading earlier in England during the 16th century.
In 1848, cereal traders founded the Chicago Board of Trade (CBOT) trading corn, wheat and soybean and later cotton, coca, orange juice and sugar as well as cattle and pork futures. In England, the first official commodities trading exchange was the London Metals and Market Exchanged, established in 1877.
Trading financial futures began trading in 1972 when the Chicago Mercantile Exchange (CME) offered foreign currency futures for trade followed by treasury bill futures in 1977 and Eurodollar contracts (1981). Stock index futures contracts began being offered in 1982 with the S&P500 futures contract.
In Australia, early futures contracts were traded at the Sydney Greasy Wool Futures Exchange (SGWFE) – later known as the Sydney Futures Exchange (SFE). THE SGWFE facilitated greasy wool futures trading as a hedge for wool traders. In Europe, the Financial Times Stock Exchange (FTSE100) futures was the first contract the London International Futures Exchange in 1984.
Today, there are more than 120 futures trading exchanges worldwide.
Due to exponential growth in futures trading in recent years, a strong and effective regulatory structure is required to ensure market integrity and investor protection. Globally, each country’s exchange is regulated by their own government regulatory authority.
Futures contracts are classified into two broad categories: ‘commodity’ futures and ‘financial’ futures.
A commodity futures contract is a binding agreement to buy (or sell) a commodity at a fixed price, on (or before) a specific date in the future. Based on the purchase (or sale) of the physical commodity, commodity futures contracts are standardised in terms of quality, quantity and delivery time.
Commodity futures contracts provide for physical delivery of the asset, however, this rarely occurs with traders typically closing out their positions before expiration. Price is determined by supply and demand.
Also known as security futures and accounting for at least 20-percent of futures trading volume, non-financial (commodity) futures are sub-classified into the follow sectors:
Under each of these sectors there is a multitude of sub futures contracts and markets available for trade.
A financial futures contract is a binding agreement to buy (or sell) the underlying commodity – a financial asset or instrument – at a fixed price at a specified future date.
Price is determined by supply and demand and delivery although typically cash settled at expiration, can be physical delivery (depending on the asset).
Financial futures comprise the following sectors:
Although financial futures markets have a shorter history than commodity counterparts, they globally dominate exchange-traded product offerings accounting for up to 80% of futures trading volume.
Futures contracts are standardised binding agreements. Asset quality, quantity as well as delivery (physical or cash settlement) are particularised by the futures contract as well as contract size, base currency and pricing unit.
Identifiers such as the symbol, expiration date and exchange indicate the market and contract traded. The multiplier (or tick size) and contract value specifies price movement and profit (or loss) potential.
The contract specifications not only provide the trader with access to market information (through exchange market data or broker websites), but also is used to configure stock market trading and charting software.
Abbreviations and Symbols
For trading and asset identification, futures contracts are represented by an abbreviation (also known as a symbol or code) – characterising both for the contract and its’ expiration. The identifying abbreviation sequence is typically two letters (representing the underlying contract code), one letter – to identify the contract’s expiration/delivery month and a final number representing the expiration year (the number if the last digit of the year).
EXAMPLE: E-mini S&P500, December 2017 contract would be abbreviated to ESZ7 whereby ES is the symbol for E-mini S&P500, Z is for the month of December and 7 represents the year 2017.
Each futures contract has an expiration date – or the date in which a futures contract expires and ceases to trade. This date designates when the underlying asset must be delivered (physically or cash settled). These expiration dates are fixed for each futures contract by the exchange that provides the market. (NOTE: The last trading day on a futures contract is the day immediately preceding a contract’s expiration date).
While most futures contracts are valid for 3-months and typically have March, June, September and December delivery months, there are futures markets which expire monthly including crude oil and some e-mini markets.
The identifier for the delivery (or expiration) month is positioned generally as the third letter of the contract symbol using the following letter codes:
Futures contracts are either cash settled or physically delivered.
Cash settlement is a method of settling a futures contracts by cash rather than by taking physical delivery of the underlying asset. Used as a settlement method to fulfil contractual obligations of the futures contract at expiration, cash settlement requires the holder of the position to debit or be credited the difference between the entry price and the final settlement price to realise either a profit or loss on the trade.
No physical asset is exchanged.
Physical delivery is the alternate method of settling a futures contract (opposed to cash settlement). Estimated to occur in only 2-percent of futures contract settlements, physical delivery upon expiration occurs when the underlying asset is physically exchanged. This requires the holder of the position to deliver the physical commodity (if the holder of a short position) or take delivery of the asset (if holding a long position).
Only after taking physical delivery is a physically delivered futures contract fulfilled.
Mini contracts are electronically traded futures contracts that represents a portion of a standard futures contract. Growing in popularity and offering particularly beginner traders the opportunity to participate in the futures market with less risk exposure, mini contracts may be 1/3rd, 1/5th or even 1/10th the size of a regular sized contract (depending on the underlying asset). Mini contracts typically have lower margin requirements (than a full-sized contract), high liquidity and lower brokerage commissions than standard sized contracts and in some countries, such as the USA, taxation concessions.
Also known as the Full Contract Value (FCV), the contract value of a futures contract is simply the total value of the assets covered by the futures contract. Calculated as the cash price of the underlying asset times the number of units in the futures contract, the contract value requires recalculation as prices adjust according to supply and demand – or market forces. The delivery (or settlement) price secures the price of the asset to be delivered at a future date.
EXAMPLE: If the E-mini S&P 500 contract is $50 times the price of the index and the index is trading at $2,425, the value of one E-mini contract would be $121,250.
Depending on settlement type, it is important to understand a futures contract value to either calculate the initial margin amount required to hold a futures position (for leverage traders) or to estimate the amount of cash required at settlement in preparation for delivery of the underlying asset.
Futures market participants are typically either hedgers or speculators.
Hedgers enter the market to manage pricing risk, protecting themselves from unfavourable price movements. A hedger is typically a commodity producer, importer, exporter or hedge fund manager.
Speculators provide liquidity to the market, having no desire to take physical delivery of the underlying asset. They rather attempt to anticipate future price movements, buying and selling futures contracts in anticipation of trading profits. Speculators are individual traders and investors may be scalpers, day or position traders.