Forward and forward contracts are contracts that allow traders, investors and commodity producers to speculate on the future price of an asset. These contracts operate as a two-party commitment allowing trading of an instrument on a future date (expiration date), at a price agreed upon at the time of contract creation.
The underlying financial instrument of a futures contract can be any type of asset: stock, commodity, currency, interest payment or bond.
However, unlike over-the-counter futures, futures are contractually standardized (as legal agreements) and are traded on specific exchanges (futures exchange). Futures contracts are therefore subject to a specific set of rules, which may include, for example, contract size and daily interest rates. In many cases, the execution of futures contracts is guaranteed by a clearing house, allowing parties to trade with reduced counterparty risks.
While primitive forms of futures markets have existed since 17th century Europe, the Dōjima Rice Exchange (Japan) is considered the first futures exchange in history. In early 18th century Japan, most payments were made in rice, so futures contracts began to be used as a way to hedge against risks associated with rice price instability.
With the democratization of electronic trading systems, the popularity of futures, along with a range of use cases, has spread throughout the financial industry.
The different functions of futures contracts
In the context of the financial industry, futures contracts generally perform some of the following functions:
Hedging and risk management: Futures contracts can be used to limit risks. For example, a farmer can sell futures contracts for his produce to ensure he gets a certain price in the future, even if market conditions are unfavorable. Alternatively, a Japanese investor who owns US Treasury bonds can purchase JPYUSD futures contracts for an amount equal to the quarterly coupon payment (interest rate) to lock in the coupon value in JPY at a predefined rate and thus hedge its exposure to the dollar.
Leverage: Futures contracts allow investors to use leverage. Since these contracts have an expiration date, investors can use leverage on their positions. For example, 3:1 leverage allows traders to have a position three times larger than their balance.
Short position: Futures contracts allow investors to take a short position in an asset. When an investor decides to sell futures contracts without even owning the underlying asset, it is called a “naked position”.
Diversify your assets: investors can gain exposure to assets that are difficult to trade on the spot market. Commodities such as oil are generally expensive to deliver and involve high storage costs. Through futures contracts, investors and traders can speculate on a wider variety of asset classes without having to physically trade them.
Price discovery: Futures markets are a one-stop shop for sellers and buyers (supply meets demand) for multiple asset classes such as commodities. For example, the price of oil can be determined based on real-time demand on futures markets, rather than by physical interaction at a gas station.
Settlement mechanism
The expiration date of a futures contract is the last day that trading activity is possible for that specific contract. After this date, trading is interrupted and the contracts are settled. There are two main settlement mechanisms for futures contracts:
Physical settlement: the underlying asset is exchanged between the two parties having agreed to a contract at a predefined price. The party that was short (selling) has the obligation to deliver the asset to the long party (buying).
Cash Settlement: The underlying asset is not traded directly. Instead, one party pays the other an amount that reflects the current value of the asset. Here's a typical example of a cash-settled futures contract: an oil futures contract, where money is traded rather than barrels of oil, as it would be quite complicated to physically trade thousands of barrels.
Cash-settled futures contracts are more convenient and popular than physically settled contracts, even for liquid financial securities or fixed-income instruments whose ownership can be transferred relatively quickly (at least in comparison to physical assets like barrels of oil).
However, cash-settled futures contracts can lead to manipulation of the price of the underlying asset. This type of market manipulation is commonly referred to as "closing change", which is a term that describes abnormal trading activities that intentionally disrupt order books when futures contracts get closer to their due date. 'expiry.
Exit Strategies for Futures Contracts
After taking a position in a futures contract, traders have three options:
Offsetting: Refers to the action of closing out a futures position by creating an inverse trade of the same value. So, if a trader is short 50 futures contracts, he can open a long position of equal size, thereby neutralizing his initial position. The netting strategy allows traders to realize their gains or losses before the settlement date.
Rollover: This occurs when a trader decides to open a new position in a futures contract after clearing their original position, thereby extending the expiration date. For example, if a trader is long 30 futures contracts expiring in the first week of January, but wants to extend their position for six months, they can offset the original position and open a new position of the same size, the date expiry being set for the first week of July.
Settlement: If a trader does not clear or rollover, the contract will normally be settled on its expiration date. At this point, the parties involved are legally required to exchange their assets (or cash) based on their position.
Futures Pricing Patterns: Contango and Downgrade
From the time futures contracts are created until they are settled, the market price of the contracts constantly changes in response to buying and selling forces.
The relationship between maturity and variable prices of futures contracts generates different pricing patterns, which are commonly referred to as contango (1) and backwardation (3). These price patterns are directly related to the expected spot price (2) of an asset on the expiration date (4), as shown below.
Contango (1): A market condition where the futures contract price is higher than the expected spot price.
Expected Spot Price (2): Anticipated price of the asset at settlement (expiration date). It should be noted that the expected spot price is not always constant, that is, it can vary depending on market supply and demand.
Downgrade (3): A market condition where the futures contract price is lower than the expected spot price.
Expiration Date (4): The last day of trading activities for a futures contract before settlement.
While contango market conditions tend to be more favorable to sellers (short positions) than to buyers (long positions), downgrade markets are generally more beneficial to buyers.
As the expiration date approaches, the price of the futures contract should normally gradually converge towards the spot price until it has the same value. If the futures contract and spot price are not the same on the expiration date, traders will be able to make quick gains through arbitrage opportunities.
In a contango scenario, futures contracts are traded above the expected spot price, usually for convenience. For example, a futures trader may decide to pay a premium for physical goods that will be delivered at a later date, so that he or she does not have to worry about paying expenses such as storage and shipping. insurance (gold is a popular voucher). Additionally, companies can use futures contracts to lock in future spending at predictable values, purchasing essential commodities for their service (example: a bread producer can buy wheat futures).
On the other hand, a backwardation market occurs when futures contracts are traded below the expected spot price. Speculators buy futures contracts in hopes of making a profit if the price rises as expected. For example, a futures trader may buy barrels of oil contracts at $30 each today, when the expected spot price is $45 for next year.
To conclude
As a standardized type of OTC futures contract, futures contracts are among the most widely used tools in the financial industry and their diverse features make them suitable for a wide range of use cases. However, it is important to fully understand the underlying mechanics of futures contracts and their particular markets before investing in them.
While “locking in” the price of an asset into the future is useful in some circumstances, it is not always safe, especially when contracts are traded on margin. Therefore, risk management strategies are often employed to mitigate the inevitable risks associated with futures trading. Some speculators also use technical analysis indicators as well as fundamental analysis in order to get an idea of price action in the futures markets.