Module 14 – Futures

Introduction

In the last few decades, futures contracts have grown from being solely for commodities to encompassing virtually any financial instrument you can think of. They started with futures contracts on currencies and treasury bonds, and then included futures on indices, and most recently single stock futures have become available.

In this module we’ll talk about the overall organization of futures contracts and the markets, and go on to explain some basic trading strategies.

What Is a Future?

Futures contracts have been around for a time, but used to be called commodity contracts when that was all they dealt in. Quite simply, a futures contract is a binding commitment to purchase or sell the ‘underlying’ at a predetermined price on a specified future date. The underlying may be a financial security of some form, or a physical commodity such as corn or beef.

Some futures contracts are settled with delivery of the underlying, for example when a cereal manufacturer takes delivery of cereal for their product, and some must be settled in cash, for example if you have a future on a stock index. All of them can be settled for cash, in the sense that they are bought and sold sometimes many times before the specified future date. It’s estimated that fewer than 4% of all futures contracts are actually traded for delivery.

Futures contracts are highly standardized, and traded on the market. You can choose from a selection of delivery months, and performance of the contract, on both sides, is assured because of the market place — in fact you’ll never know who was on the other side of the contract. And because there are two sides to the contract, and you can take either side, whether it’s supplying or buying the underlying, it’s fundamentally a zero sum exercise – what you make, the other guy loses.

Now it’s because futures contracts have become so regulated and standardized that you can have a rational trading market in them. You may also hear about forward contracts, and these are the same thing but customized to the buyer and seller. Finance houses quite often set up a forward contract to suit their precise needs.

When you buy a car, you do something similar to a forward contract if the dealer doesn’t have the color and options you want in stock. You agree the specification and price with the dealer, and he gives you the date of delivery. Because forward contracts are specific to the buyer and seller needs, they are not generally traded. And forward contracts are between two parties, either of whom could default on the contract — that doesn’t arise with futures, because the market will guarantee performance to you regardless of what someone else does.

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