A futures contract is a type of derivative in which two parties make a legally binding agreement. They agree to take or make delivery of a specific quantity of a specified asset on a future date but for a price that they agree today. In the most common form you are agreeing to buy something that the seller has not yet produced and for a price that is fixed when you exchange the contract.
Trading futures does not necessarily mean have to ready yourself for 200 tonnes of Wheat arriving on your doorstep. The primary focus of traders in the futures market is to hedge and speculate as appose to actually exchanging the goods. Those looking to actively buy the asset often use the cash market to enable immediate delivery.
The terms of the contract are set in a legal document called the ‘contract specification’. The contract sizes and delivery dates are fixed so it is easier for the exchange to match orders accurately. This ‘contract specification’ also goes into detail confirming what is considered deliverable grade and to where the delivery should be made. Different assets have varying delivery months and contract sizes. Contracts that are identical in terms of the underlying and delivery month are said to be ‘fungible’ and this makes trading of the contracts far easier.
Due to this fungible nature it is a simple task for a trader to remove his delivery obligation by taking an equal position in an opposite trade. For example if a trader holds a long position (has agreed to buy at a future date) he can take a fungible short position (agrees to sell at a future date) and therefore has closed out his position.
The origins of futures contracts are located in the agricultural market and were initially associated with cereal commodities. More recently financial futures have become a popular area of investment with contracts being made available on currencies, rates and indices.
The most common misconception surrounding futures is that the price is an indication of anticipated movements in the cash price. For example Gold’s daily cash price maybe $1150, whereas the futures price for March delivery is $1159. This premium is not reflective of an expected price rise; it is actually related to the ‘cost to carry’. The cost to carry is usually a calculation based on the risk free interest that could be accrued on your cash because you do not have to pay for the asset until a future date. For physical assets this will also take into account the storage and insurance costs that the seller will incur over the period. In theory as the contract nears maturity there should be a narrowing of this premium to the point of ‘spot-future parity’ where both prices are identical as the cost to carry is no more.
The futures market is extremely liquid, due to the above, but also very risky and complex. Leverage is widely used by speculators and the term ‘lost the shirt of his back’ is not uncommon when discussing futures failings. Despite this risk they are used by a wide range of producers and investors. Investors considering trading futures are wise to spend extended time discussing the vehicle with an experienced CFD broker.