A future contract is a legal agreement for a buyer to buy a certain amount of goods (or a seller to sell a certain amount of goods) at a predetermined future date and price.
Futures contracts are traded at a centralized financial exchange.
Each future contract is based on an underlying asset. This underlying asset is the good that is exchanged at a future date
Today (9th April 2019), trader X buys 1 contract (1000 barrels) of crude oil futures at $60 with an expiry on 30th June 2019 from trader Y. In other words, trader Y sold 1 contract of crude oil futures at $60 to trader X.
On 30th June 2019, trader X is required to buy 1000 barrels of crude oil from trader Y at $60. Trader Y is required to sell 1000 barrels of crude oil to trader X.
If the actual crude oil (more specifically, WTI oil) is priced at $65 on 30th June, trader X profits as he can buy the oil at $60 and immediately sell it at $65. Conversely, trader Y will lose as he has to buy the oil at $65 from the market to sell it at $60 to trader X.
Purpose of Futures
There are 2 main purposes to trading futures – 1) Speculation and 2) Hedging.
Traders make bets on the future price changes of certain assets. They trade futures instead of the underlying asset as it is more conveniently and cheaper.
Companies hold commodities for their business operations. An airline uses jet fuel for its planes. Thus, to protect against raising prices, they buy jet fuel futures.
Financial institutions hold various assets and have exposures to certain market risks. They buy and sell futures to protect themselves against unwanted risks.
Settlement is the process in which the underlying good of the futures contract is exchanged. There are 2 kinds of settlement – 1) physically delivery and 2) cash-settled.
The seller of the futures contract must deliver the specified goods to the buyer.
The trader who made a lost on the trade will pay the other party the amount he lost.
In the above crude oil example, trader Y has to pay trader X $5000 (($65-$60)*1000 barrels) when the futures contract expires on 30th June 2019.
There are 2 popular pricing theories – 1) Arbitrage and 2) Expectations
Arbitrage is a fancy word that describes a scenario where 2 similar assets should be similarly priced, accounting for any limitation.
This pricing theory states that a futures contract should be priced similarly to its underlying product, accounting for any holding or opportunity costs.
This theory states that a futures contract should be priced higher if the market expects the price of the underlying to be higher in the future, and vice versa.
Examples of Popular Futures Contracts
- S&P 500 E-mini (ES)
- 10 Year T-Notes (ZN)
- Crude Oil (CL)
- Gold (GC)
Links to Complicated Explanations