An Introduction To Futures

Futures are probably one of the least well understood derivative markets amongst regular investors, and yet they have become the instrument of choice amongst market professionals, from Commodity Trading Advisors and Commercial Hedgers to Global Macro Funds and Floor Traders. Over the last ten or more years volumes have grown across a range of futures products, with the introduction of smaller sized electronically traded contracts witnessing a surge in popularity. In 2014, the number of futures contracts traded worldwide exceeded 21.8 billion.

An Introduction To Futures

Although futures began as a standardized form of exchange of forward contracts for the producers and consumers of agricultural commodities such as grains and cattle, these contracts now cover all of the major market groups, from currencies and stock indexes to precious metals, energies, and interest rate products. The agricultural sector now accounts for only a small proportion of trading volumes.

Who trades in the futures markets? There are a very diverse range of participants, but they can be broadly divided into two categories: hedgers who seek to insure themselves against price risk, and speculators who facilitate the transfer of this risk in the hope of profiting from correctly predicting future price movements. Because of their exposure to the real commodity or asset that underlies a futures contract, hedgers aren’t concerned with changes in price once they have entered the market; speculators, on the other hand, have complete directional exposure. You can find out more about how these two types of trader interact in this article.

Trading in a futures market involves the exchange of a standardized contract for a commodity or asset, to be fulfilled or ‘delivered’ at a future date rather than at the current time. Futures initially provided a method for consumers to lock in or ‘hedge’ against future price increases, and for producers to insure against future price declines. For example, if a food producer requires wheat to manufacture one of its products, and is concerned about a price rise, it can buy wheat futures now to protect against this and guarantee the current price for the time of delivery. If future prices are higher then the profit from the contract will offset the additional cost of the commodity, and if prices have declined then the saving in the commodity purchase will offset the losses from the futures contract.

While hedgers are able to use futures to eliminate price risk, the markets facilitate the transfer of this risk through a second group of participants: speculators. By speculating on future price direction, everyone from individual traders to large trend following funds seek to profit from anticipated price changes. The huge number of traders wishing to speculate in the futures market means that these instruments tend to be highly liquid and extremely efficient in terms of trading costs. Because all trades are guaranteed by the clearing houses of the exchange, there is virtually no counterparty risk, and the exchanges and brokerage firms at the centre of the futures industry are all heavily regulated, meaning that the market is considered relatively safe despite the high levels of leverage available.

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