Introduction to financial markets
In its traditional form, a futures contract is an agreement by one party to take delivery of something, usually a commodity or financial instrument, at a specified future date for a pre-determined price.
What are futures contracts used for?
Futures contacts are useful for buyers and sellers because they help to guarantee the price of goods in the future. Futures originated in the agricultural industry as buyers and sellers of commodities wanted to guarantee the price of crops in the future.
How do they work?
Futures trading can take place on an exchange or directly between investors (OTC).
This is a central marketplace where standardised contracts are traded. Examples of major futures exchanges include the Chicago Mercantile Exchange (CME), ICE (Intercontinental Exchange) and LIFFE (London International Financial Future Exchange).
On exchange, contracts are standardised in terms of quality, quantity and settlement dates.For example, an oil contract trading on the New York Mercantile Exchange (NYMEX) will consist of a 1000 barrels of West Texas Intermediate (WTI) oil of a particular quality.
A futures contract has a date – e.g. March 2018. This means that at the end of that month, the holder of the contract is obliged to take delivery of that asset – e.g. a barrel of oil – at that price. Refer to the market info sheet for the date the future contract expires. The month quoted in the contract title is not always the month in which the contract expires.
Futures contracts are quoted with the month at the end of which that contract matures – e.g. Crude Oil June. You can see multiple prices for oil or gold, for example, because each price is attached to a different contract.
Over the counter
The buying and selling of futures can take place between different parties off exchange. The contracts are not as highly regulated and standardised as trading on an exchange.
Example of a futures trade
A food producer wants to make sure he can buy wheat at $200 per tonne in March 2018 to guarantee his profit margins in case the price of wheat rises in the future.
By purchasing wheat contracts, he knows he will be able to take delivery of the wheat he needs at $200 per tonne. If the spot price of wheat is cheaper in March 2018, he will be buying expensive wheat, but he has hedged against the potential cost of the wheat rising above $200.
Because futures can be traded, if the price of wheat did go above $200/tonne, then that contract becomes more valuable. If the price of wheat rose, for example, to $250/tonne, the contract continues to give you the right to take delivery at $200, and you can use it to buy wheat at a cheaper rate than the current market price. By buying and selling contracts, traders can take a view on future commodity prices without ever needing to take delivery.
Stock index futures
Futures can be used to take a position on stock market indices when the market is closed. For example, futures on the Dow Jones Industrials index start trading in Chicago well before the actual New York market opens. This lets traders start trading the market in advance of its actual open.
Who trades futures?
Traditionally, it was companies seeking to off-load the risk of volatility and hedge the price of the asset they were buying and selling. However, this has now grown to include many speculators , typically investors who have a view on which direction a market will move. They assume risk and provide liquidity to a market.
Trading CFDs on the futures markets
- You can trade the price of futures markets using CFDs
- These have the advantage of not requiring you to take delivery of an asset when the contract matures
- They also let traders access futures price movements more cost efficiently than buying actual futures contracts
- City Index CFDs will typically use the next contract to mature as the basis for the price. Once that contract matures, City Index will start using the next contract in line