What are Futures?
While many have heard tell of the stock market, fewer are aware of the futures markets, their purpose, and their function. If one believes a company, or a company set in an index or ETF, are potentially going to increase in value, they can purchase shares of those companies at their current price, and then hold those shares for a given time period before hopefully selling them for profit if the value did increase. But what if someone wanted to employ that strategy, not to a specific company, but to a commodities market? What if they wanted to make an investment on the movement of crude oil prices, for instance?
If that person is not established in the physical crude oil market with something like a refinery or a well, then options are limited. It is not exactly feasible to order several barrels of crude to one’s house, sit it in the garage for a few months, then try to sell it for a higher price on Ebay. Futures allow a trader to participate in these potential price movements through the buying and selling of futures contracts, without having to actually buy or sell the underlying commodity.
Here is where futures differ from stocks. Stocks are securities, so when a company’s shares are purchased, the investor gains an actual percentage ownership of the company. Futures, on the other hand, are a derivative financial contract. Buying a futures contract does not grant ownership of the underlying commodity, and selling a futures contract does not grant ownership of the capital from that sale.
Anatomy of a Futures Contract
Before taking a venture into futures trading, it is important to focus on is the anatomy of a futures contract. First is the asset class underlying the contract. Since futures are a derivative, there is always an underlying commodity from which the contract derives its value. Asset classes include the aforementioned crude oil, agricultural commodities such as corn and soybeans, and precious metals. Futures’ underlying assets even include non-commodity products such as currency futures, treasuries such as bonds, and equity indices like the S&P 500.
The next piece of a futures contract is the quantity or size of the contract: how much of the underlying asset is being bought or sold when the contract is entered? For that crude oil contract, the size for both US WTI light sweet crude and UK Brent crude is 1000 barrels per contract, with the prices quoted in U.S. dollars and cents per barrel. For some asset classes, such as the S&P 500 stock index, there are several different contracts with varying quantities. A full S&P 500 futures contract is $250 times S&P 500 index price, while the commonly traded E-mini S&P 500 futures contract is $50 times the S&P 500 index price. The Chicago Mercantile Exchange recently launched a series of micro E-mini futures. The Micro E-Mini S&P 500 futures contract size is $5 times the value of S&P 500 index.
The next important component of a futures contract’s anatomy is the expiration or delivery date. A futures contract, as the name suggests, is an agreement to purchase or sell the underlying commodity at a future date at a predetermined price. The expiry date marks the final day the contract can be traded and by extension, after the expiry date the contract must be settled according to the terms of the agreement. If the expiry date, also known as the delivery date, is reached on one contract of WTI crude oil, then the buyer and seller will exchange the asset or cash value equivalent according to the terms of settlement for the contract.
Other aspects that will often appear when viewing a futures price quote include the abbreviated symbol for the contract, as well as basic data for that contract. This includes the current strike price, which represents what the buyer would pay per unit, as well as the high and low prices for the day, the opening price, as well as the settled closing price for the end of the last trading sessions. In addition to price data, quotes are also often listed with the volume, which is the number of contracts that have been traded during the session, as well as the open interest, which is the number of outstanding contracts. A contract is open when a trader has executed a buy or sell, having not yet closed the trade by entering a contract with an opposite leg.
Below is a hypothetical example for a futures order ticket. It includes the contract name, E-mini S&P 500 (Symbol: ES), with an expiration of December 2020. The ticket includes the last price, as well as the opening, low, and high prices for the trading session, along with the volume. Most futures quotes also include the change for that day’s trading session (up 4.50 or 0.156%).
Included in the order ticket, along with the relevant information for the contract, is the option to buy or sell. Buying a futures contract is called taking on a long position, while selling is called taking a short position or “shorting” the commodity. While waiting for the futures contract to expire so one can accept delivery of the underlying asset at the price the contract was originally purchased, most futures trades end with the trader taking on an equivalent offsetting position.
For instance, if a trader chose to place a buy order for one E-mini S&P 500 December 2019 (ES 12/19), and received their fill at the $2894.75 price, then they would have an open long position. They have entered into a binding agreement to purchase one contract of ES 12/19 at 2894.75 when the expiration date comes, regardless of the actual value of the underlying commodity at that date. This means that in order for profit to occur on this contract, the ES 12/19 must increase in value before the expiration date. Contrastly, a short position, or a sell, is a trader predicting that the contract will decrease in value.
A few days pass, and the new price of ES 12/19 is $2902.75. The contract has increased in value by $8.00. The trader now wishes to close their position and collect their profits. In order to do this, they take on a short position in ES 12/19 and receive the current fill price. A trader cannot have both a short and a long position at the same time, and so now the trader is considered “flat”, and has profited, after any applicable commissions or fees, $400 from the trade, which represents the $8.00 price move multiplied by the $50 contract size of the ES.
Margin and Leverage
One detail left out of the above example is the fact that, before the trade was offset, the value of the original position, based on the size of a single ES contract, was $144,737.50. This is over three times the 2018 median income for an American full-time employee, which seems to present an enormous barrier of entry to trade futures, as the majority of people do not have that kind of cash sitting around to even begin trading. Fortunately, futures trading involves something called margin which, although futures trading is still not suitable for everyone, does lower the initial barrier of entry to open a futures contract.
Margin exist in part because of the nature of futures trading, and the reality that most traders never intend to accept delivery on a contract. Using the example above, the trader does not actually plan on purchasing almost $150k in the S&P 500 when December rolls around, but instead offsetting that position with a sale, profiting or losing based on the price move. Therefore, when the trader opens that initial position, they need only a good-faith down-payment; a deposit known as the margin requirement. For margin rates vary between 5% and 15% of the total contract value, depending on the commodity.
Margin in futures is set at two levels: initial margin and maintenance margin. Initial margin is the cash needed to open a futures position, while the maintenance margin is the minimum level an account balance may fall before a deposit is required to return it to the initial margin level. If the initial margin for the ES position was around that 5% level, let’s say $7,500, then to buy one contract of ES 12/19, the trader would need that $7,500 as opposed to the full $144,737.50. If the maintenance margin was $6,000, then a drop in the ES 12/19 substantial enough to bring the account balance below that level would trigger a margin call, requiring a deposit to recoup the balance to $7,500. In the example above, this would require the ES 12/19 dropping by more than 30 points to below $2,864.75, based on a $30 move multiplied by a $50 contract value resulting in a $1,500 loss on the contract.
The margin structure for futures trading gives the investor an incredible amount of leverage when trading. In the example given above in Trading Futures, a $8.00 price move resulted in a $400 cash gain when the position closed; a 5.33% gain on a single trade when factoring in the $7,500 initial deposit. Conversely, in the maintenance margin example a $30 price move resulted in a $1,500 loss, or 20%. Leverage is the ability to control a large asset value with a relatively small amount of capital i.e. taking a position in a six-figure index futures contract with an investment of $7,500. Leverage in futures provides the investor immense upside, while also creating substantial risk of loss.
Hedgers vs Speculators
The examples given above most likely describe a speculator: a trader who does not own an equivalent cash position in the contract’s underlying asset, but instead desires a chance to profit by predicting moves in that asset. The leverage provided by futures markets allows many retail traders to make these speculative trades, while in turn providing increased liquidity and price stabilization through added volume to the asset.
The second purpose of the futures market is also another aspect of that price stabilization. Hedging is the use of a derivative asset class to mitigate risk for a cash position in the underlying asset. This tactic is most often utilized by business involved in the buying or selling of the underlying asset. Most cases of hedging futures are fairly intuitive: a corn farmer with large inventories of the grain would suffer substantial loss if the price of corn dropped before they could sell their supplies. Therefore, they take on an equivalent short position in the corn futures market to dull the effect of price moves. This maintenance of price volatility goes both ways. Theoretically, the price of corn could skyrocket, increasing the value of the farmer’s cash position. The short futures position, however, would correspondingly suffer a loss. For the hedger, going flat with a hedge that in hindsight was unnecessary is preferable to the crippling risk of loss in a naked cash position.
The initial purpose of futures markets was this type of commodity hedging, both for sellers of the underlying commodity, and for potential buyers, such as a grain processing facility that has to purchase corn to turn into cereals. For that business, an increase in the value of corn would result in a loss, so a hedging in futures in that instance would involve a long position. With the advent of non-commodity futures products, more hedging avenues have been opened. If a stock trader has $150,000 in the S&P 500 and fears a bearish trend on the horizon, they can take an equivalent short position using S&P 500 futures to mitigate that risk.