What are Futures Contracts?

What are Futures?

A futures contract is an obligation (that is, a legally binding agreement between a buyer and seller) to receive (in the case of a long position) or deliver (in the case of a short position) a commodity or financial instrument sometime in the future, but at a price that’s agreed upon today. These contracts mature at a particular point in the future and are identified by reference to that date –for instance, a December Gold futures contract or a June 2012 Emini S&P 500 index futures contract. The ability to make or take delivery of the underlying commodity at the expiration creates a strong tendency for cash and futures prices to move in the same direction by roughly equal amounts, reacting to the same economic factors.

A Primer on Futures Trading Basics

Futures trades take place at any of the centralized exchanges. (example: CBOT, CME, NYMEX, COMEX, CSCE, etc) often in the open-outcry, auction style trading octagons, but electronic trade-matching platforms like the CME Globex system, for example are growing more and more important every year. In every transaction, the exchange clearinghouse is substituted as the buyer to the seller and the seller to the buyer thereby guaranteeing performance and eliminating counterparty risk. Customers who trade futures are required to post margin deposits with an exchange member firm (Like our FCM Vision Financial Markets) which, in turn, must deposit margin with the exchange. Margins are not payment against the market value of the commodity represented by the futures contract, but rather, are a performance bond (a good faith deposit) to ensure the ability of the market participants to honor their financial commitments and cover any obligations which might arise out of their trading activities.

Buying a futures contract is also known as taking a "long" position. If you Sell a futures contract, that is referred to as taking a “short” position. A long futures position makes a profit when the futures price goes up, and the short futures position profits when the futures price goes down. Maturing futures contracts expire on specific dates, usually during the contract month. At any time before the contract matures, the trader may offset, or close out, the obligation by selling what you had previously bought or buying what you had previously sold. By offsetting an open futures contract, a trader is relieved of any obligation to make or take delivery of the underlying commodity or financial instrument. This is made possible by the fact that futures contracts have standardized terms and trade on centralized exchanges. The majority of futures contracts are closed out by offsetting transactions prior to their maturity, rather than through the delivery process.

Futures Exchange, Clearing Firms, and Market Participants

U.S. futures exchanges typically operate with a trading floor where traders and brokers compete on equal footing in an auction-style, open-outcry market and where they communicate by voice and hand signals with others in the pit. Customer orders coming into the futures pit are delivered to floor brokers who execute them with other floor brokers representing other public customers or with floor traders known as “locals”, trading for their own accounts.
Trading by means of other electronic order matching has recently taken off and is surpassing those that are executed in the pit. Electronic trading is becoming the normal type of business nowadays even though there is still an open-outcry, auction-style pit presence during regular business hours.

Traditionally, each U.S. futures exchange has had its own clearinghouse that acts as the master bookkeeper and settlement agent. In every matched transaction executed through the exchanges facilities, the clearinghouse is substituted as the buyer to every seller and the seller to every buyer. The clearinghouse deals exclusively with clearing members and holds each clearing member responsible for every position it carries on its books, regardless of whether the position is being carried for the account of a non-member public customer or for the clearing member’s own account. The clearinghouse doesn’t look to public customers for performance or attempt to evaluate their creditworthiness or market qualifications. Instead, the clearinghouse looks solely to the clearing member carrying and guaranteeing an account to secure all margin requirements and payments. The clearinghouse system is an important aspect of the financial integrity of the futures market.

A futures brokerage firm, known in the U.S. as a futures commission merchant (FCM), is the intermediary between public customers and an exchange. An FCM may be a full service firm, a discount firm or both. Some FCMs are part of a national or regional brokerage companies that also offer stock trading and other financial services, while other FCMs offer only futures and futures options. An FCM maintains records of each customer’s open futures and futures options positions, margin deposits, money balances and completed transactions. In return for providing these services – and for guaranteeing the accounts carried on its books to the exchange clearinghouse – an FCM earns commissions. By U.S. law, an FCM is the only entity, outside a futures clearinghouse, that can hold the funds of futures customers.

Federal Law also requires an FCM to segregate customer funds from the firm’s own funds at all times. The funds in segregation must be sufficient to meet the firm’s obligations to customers, and the FCM may not use those funds to satisfy any of its own obligations to creditors. Furthermore, an FCM must deposit its own funds to cover any customer-account deficits until the customer remits sufficient funds. Segregation of funds is designed to protect customer funds and make it possible to identify such funds in the event of an FCM’s default or bankruptcy.

Futures Market Participants: Hedgers and Speculators

Futures market participants may be divided into two broad categories: Hedgers, who actually deal in the underlying commodity or financial instrument and seek to protect themselves against adverse price fluctuations, and speculators (including professional floor traders), who seek to profit from price swings.

The futures markets exist to facilitate the management of risk and are thus used extensively by hedgers-individuals or businesses who have exposure to the price of an agricultural commodity, or currency, or interest rates, for instance, and take futures positions designed to mitigate their risks. This requires the hedger to take a futures position opposite to that of his or her position in the actual commodity or financial instrument. For example, a corn farmer is at risk should the price of the commodity fall before he harvests and sells his crop. A short position in the futures market will return a profit when the price of corn declines and the hedger’s profit on the short futures position compensates for the loss on the physical commodity.

Speculators are attracted to futures trading purely and simply because they see the opportunity to profit from price swings in commodities and financial instruments. Speculators take advantage of the fact that the futures markets offer them access to price movements; the ability to offset their obligations prior to delivery; high leverage (low margin requirements); low transaction costs; and ease of assuming short as well as long positions. (In futures trading, unlike stock trading, taking a short position is not subject to the uptick rule, nor to any broker/dealer interest charges) In pursuit of trading profits, speculators willingly take risks that hedgers wish to transfer. In this process, speculators provide the liquidity that assures low transaction costs and reliable price discovery, market characteristics which, in turn, make futures markets attractive to hedgers.

Regulation of the Futures Markets

The Commodity Futures Trading Commission (CFTC) is the federal agency that regulates the futures markets. The mission of the CFTC, which was created by Congress in 1974, is to protect futures market participants against manipulation, abusive trade practices and fraud; to guarantee the integrity of futures market pricing; and to assure the financial solvency of futures brokerage firms, exchanges, and clearinghouses. The CFTC’s oversight and regulation help assure that futures markets provide effective price discovery and risk-transfer opportunities. You can get more information regarding the CFTC and their activities by visiting their site at www.cftc.gov