Futures Market Definition
By JAMES CHEN
Updated Dec 26, 2020
What Is a Futures Market?
A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts that lock in future delivery of a commodity or security at a price set today.
Examples of futures markets are the New York Mercantile Exchange (NYMEX), the Kansas City Board of Trade, the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), Chicago Board Options Exchange (CBOE) and the Minneapolis Grain Exchange.
Originally, such trading was carried on through open outcry and the use of hand signals in trading pits, located in financial hubs such as New York, Chicago, and London. Throughout the 21st century, like most other markets, futures exchanges have become mostly electronic.
- A futures market is an exchange where futures contracts are traded by participants who are interested in buying or selling these derivatives.
- In the U.S. futures markets are largely regulated by the commodities futures clearing commission (CFTC), with futures contracts standardized by exchanges.
- Today, the majority of trading of futures markets occurs electronically, with examples including the CME and ICE.
- Unlike most stock markets, futures markets can trade 24 hours a day.
The Basics of a Futures Market
In order to understand fully what a futures market is, it’s important to understand the basics of futures contracts, the assets traded in these markets.
Futures contracts are made in an attempt by producers and suppliers of commodities to avoid market volatility. These producers and suppliers negotiate contracts with an investor who agrees to take on both the risk and reward of a volatile market.
Futures markets or futures exchanges are where these financial products are bought and sold for delivery at some agreed-upon date in the future with a price fixed at the time of the deal. Futures markets are for more than simply agricultural contracts, and now involve the buying, selling and hedging of financial products and future values of interest rates.
Futures contracts can be made or “created” as long as open interest is increased, unlike other securities that are issued. The size of futures markets (which usually increase when the stock market outlook is uncertain) is larger than that of commodity markets, and are a key part of the financial system.
Major Futures Markets
Large futures markets run their own clearinghouses, where they can both make revenue from the trading itself and from the processing of trades after the fact. Some of the biggest futures markets that operate their own clearing houses include the Chicago Mercantile Exchange, the ICE, and Eurex. Other markets like CBOE and LIFFE have outside clearinghouses (Options Clearing Corporation and LCH.Clearnet, respectively) settle trades.
Most all futures markets are registered with the Commodity Futures Trading Commission (CFTC), the main U.S. body in charge of regulation of futures markets. Exchanges are usually regulated by the nations regulatory body in the country in which they are based.
Futures market exchanges earn revenue from actual futures trading and the processing of trades, as well as charging traders and firms membership or access fees to do business.
Futures Market Example
For instance, if a coffee farm sells green coffee beans at $4 per pound to a roaster, and the roaster sells that roasted pound at $10 per pound and both are making a profit at that price, they’ll want to keep those costs at a fixed rate. The investor agrees that if the price for coffee goes below a set rate, the investor agrees to pay the difference to the coffee farmer.
If the price of coffee goes higher than a certain price, the investor gets to keep profits. For the roaster, if the price of green coffee goes above an agreed rate, the investor pays the difference and the roaster gets the coffee at a predictable rate. If the price of green coffee is lower than an agreed-upon rate, the roaster pays the same price and the investor gets the profit.
Why would you buy futures?
By KUSHAL AGARWAL
Updated Apr 19, 2020
Futures are derivative contracts that derive value from a financial asset, such as a traditional stock, bond, or stock index, and thus can be used to gain exposure to various financial instruments, including stocks, indexes, currencies, and commodities. Futures are a great vehicle for hedging and managing risk; If someone is already exposed to or earns profits through speculation, it is primarily due to their desire to hedge risks.
Future contracts, because of the way they are structured and traded, have many inherent advantages over trading stocks.
- Futures Are Highly Leveraged Investments
To trade futures, an investor has to put in a margin — a fraction of the total amount (typically 10% of the contract value). The margin is essentially collateral that the investor has to keep with their broker or exchange in case the market moves opposite to the position they have taken and they incur losses. This may be more than the margin amount, in which case the investor has to pay more to bring the margin to a maintenance level.
What trading futures essentially means for the investor is that they can expose themself to a much greater value of stocks than he could when buying the original socks. And thus their profits also multiply if the market moves in his direction (10 times if margin requirement is 10%).
For example, if the investor wants to invest $1250 into Apple (APPL) stock priced at $125, they can either buy 10 stocks or a future contract holding 100 Apple stocks (10% margin for 100 stocks: $1250). Now assuming a $10 increase in price of Apple, if the investor would have invested in the stock, they would earn a profit of $100, whereas if they took a position in an Apple future contract, their profit would be $1000.
- Future Markets Are Very Liquid
Future contracts are traded in huge numbers every day and hence futures are very liquid. The constant presence of buyers and sellers in the future markets ensures market orders can be placed quickly. Also, this entails that the prices do not fluctuate drastically, especially for contracts that are near maturity. Thus, a large position may also be cleared out quite easily without any adverse impact on price.
In addition to being liquid, many futures markets trade beyond traditional market hours. Extended trading in stock index futures often runs overnight, with some futures markets trading 24/7.
- Commissions and Execution Costs Are Low
Commissions on future trades are very low and are charged when the position is closed. The total brokerage or commission is usually as low as 0.5% of the contract value. However, it depends on the level of service provided by the broker. An online trading commission may be as low as $5 per side, whereas full-service brokers may charge $50 per trade.
Note that online brokers are increasingly offering free stock and ETF trading across the board, making the transaction cost proposition for futures a bit less attractive than it had been in the past.
- Speculators Can Make Fast(er) Money
An investor with good judgment can make quick money in futures because essentially they are trading with 10 times as much exposure than with normal stocks. Also, prices in the future markets tend to move faster than in the cash or spot markets.
A word of caution, however: Just as wins can come quicker, futures also magnify the risk of losing money. That said, it could be minimized by using stop-loss orders. Because futures are highly leveraged, margin calls might come sooner for traders with wrong-way bets, making them potentially a more risky instrument than a stock when markets move fast.
- Futures Are Great for Diversification or Hedging
Futures are very important vehicles for hedging or managing different kinds of risk. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk by locking in a interest rate in anticipation of a drop in rates if they have a sizable investment to make, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs. Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock.
- Future Markets Are More Efficient and Fair
It is difficult to trade on inside information in future markets. For example, who can predict for certain the next Federal Reserve’s policy action? Unlike single stocks that have insiders or corporate managers who can leak information to friends or family to front-run a merger or bankruptcy, futures markets tend to trade market aggregates that do not lend themselves to insider trading. As a result, futures markets can be more efficient and give average investors a fairer shake.
- Futures Contracts Are Basically Only Paper Investments
The actual stock/commodity being traded is rarely exchanged or delivered, except on the occasion when someone trades to hedge against a price rise and takes delivery of the commodity/stock on expiration. Futures are usually a paper transaction for investors interested solely on speculative profit. This means futures are less cumbersome than holding shares of individual stocks, which need to be kept track of and stored someplace (even if only as an electronic record). Companies need to know who owns their shares in order to pay out dividends and to record shareholder votes. Futures contracts don’t need any of that record keeping.
- Short Selling Is Easier
One can get short exposure on a stock by selling a futures contract, and it is completely legal and applies to all kinds of futures contracts. On the contrary, one cannot always short sell all stocks, as there are different regulations in different markets, some prohibiting short selling of stocks altogether. Short selling stocks requires a margin account with a broker, and in order to sell short you must borrow shares from your broker in order to sell what you don’t already own. If a stock is hard to borrow, it can be expensive or even impossible to short sell those shares.
The Bottom Line
Futures have great advantages that make them appealing for all kinds of investors — speculative or not. However, highly-leveraged positions and large contract sizes make the investor vulnerable to huge losses, even for small movements in the market. Thus, one should strategize and do due diligence before trading futures and understand both their advantages as well as their risks.