Futures contracts are derivative investments traded on an open auction market through specialized exchanges. Futures contracts derive their value from the underlying asset the contract represents.
The futures market enables buyers and sellers of commodities and financial instruments to execute transactions where the buyer is obligated to purchase an asset and the seller is obligated to sell an asset for a predetermined price on or before a predetermined date. Futures contracts have expiration dates, similar to options contracts. The terms of a futures contract outline the expiration date and the agreed-upon price of a commodity or index.
Futures contracts have standardized pricing. Each point or tick is equal to a specified dollar amount that derives its value from the underlying security. Futures contracts may be cash-settled or may have physical delivery in the case of some commodities.
Assets traded in the futures market include financial indexes, currencies, interest rates, metals, energy, agricultural, meats, etc. Multiple futures markets enable investors to trade futures contracts, such as the New York Mercantile Exchange, Chicago Mercantile Exchange, Chicago Board of Trade, Chicago Board Options Exchange, etc. Futures markets typically have much longer trading hours than equity and index markets and are open for trading nearly all day.
Because futures enable investors to lock in a security at a specific price for a future date, they can be used to speculate on future price movement or hedge positions against adverse price changes. Futures markets utilize margin and provide investors with high leverage because the contract’s value is derived from the underlying asset.
Initial and maintenance margin requirements are lower for futures contracts than for stock purchases and provide the opportunity for significant leverage. Futures contracts must be exited by the date of expiration or rolled out to a future expiration date to avoid costly penalties.
Index futures are futures contracts that allow investors to buy or sell equity indices at an established price at the time of the transaction to be settled at a later date as determined by the terms of the contract. Because the actual physical delivery of a market index is not possible, index futures are cash-settled. Index futures derive their value from the underlying index and each point value is a specified multiple of the underlying security.
For example, the E-Mini S&P 500 futures contract is a derivative of the S&P 500. It has a value of 50 times the underlying index. If the S&P 500 is trading at 3,000, then the notional value of the E-Mini S&P 500 futures contract is $150,000.
Index futures are typically used to speculate on the underlying index’s future direction or hedge existing equity positions.
Currency futures contracts define the price to exchange one currency for another currency at a predetermined future date. Currency futures prices are derived from the spot price of currency pairs. The spot price refers to the current quote that one currency can be exchanged for another currency for immediate settlement.
Large corporations often use currency futures if a significant portion of their revenue derives from payments from foreign countries. Futures contracts help to reduce currency risk by hedging against adverse changes in foreign exchange rates.
Currency futures often allow higher amounts of leverage than index or commodity futures.
Interest rate futures
Interest rate futures are futures contracts where the underlying derivative pays interest, such as a Treasury bill. An interest rate futures contract provides the investor with exposure to securities impacted by changes in interest rates.
Interest rate futures prices move inversely to interest rates, so when interest rates decrease, the interest rate futures price increases. Interest rate futures contracts are often used to hedge bond portfolios.
Like currency futures, interest rate futures offer high amounts of leverage. For example, initial margin requirements for a 30-yr Treasury futures contract may be $5,000 to $10,000 for a contract with a notional value of $100,000.
Futures contracts for precious metals offer investors the opportunity to gain exposure to the metals market without owning physical assets such as gold and silver. Metals, such as gold, are often used by investors as a hedge against adverse moves in the stock market and future inflation. Metals futures are often physically settled, so traders usually close positions prior to expiration to prevent the underlying asset’s delivery.
The multiplier for a metals futures contract varies from metal to metal. For example, one COMEX gold futures contract represents 100 troy ounces of gold. If gold is quoted at $1,800 per ounce, then a gold futures contract has a notional value of $180,000.
Energy futures contracts provide investors with exposure to fossil fuel-related products. Energy futures are offered on physical commodities such as oil, natural gas, energy, electricity, and more. Energy futures are primarily used by large energy companies to help offset risks of future supply and demand issues. Energy futures are often physically settled, so traders usually close positions prior to expiration to prevent the underlying asset’s delivery.
The multiplier for an energy futures contract varies depending on the underlying asset. For example, one NYMEX WTI crude oil futures contract represents 1,000 barrels of crude oil. If WTI crude oil is quoted at $40 per barrel, then a crude oil futures contract has a notional value of $40,000.
Agricultural futures include dairy, lumber, grains, soybeans, corn, wheat, and more. Agricultural futures allow investors to speculate on the future price movements of individual products within the agriculture industry.
Agricultural futures were originally created to assist farmers in hedging their crops from adverse supply and demand issues. For example, a farmer could lock in a price for their commodity at a future date to protect against poor weather conditions or large changes in supply from a strong growing season. The farmer could sell futures contracts representing all or some of the anticipated crop, locking in the crop price, and delivering the crop on the contract’s expiration date.
Agricultural futures are also used to speculate on price moves and offer significant leverage opportunities. Contract specifications vary for the underlying commodities. For example, one Chicago SRW wheat futures contract represents 5,000 bushels of wheat.
Meat futures include livestock such as cattle and hogs. Meat futures allow investors to speculate on the future price movements of individual products within the livestock industry. Like agricultural futures, meat futures provide farmers with an opportunity to protect their livestock inventory from future supply and demand issues.
The contract specifications and multiplier for a meat futures contract varies for each underlying asset. For example, one CME Group lean hog futures contract represents 40,000 pounds of lean hog. If lean hog futures are quoted at $50 per pound, then a lean hog futures contract has a notional value of $2,000,000.
Softs future commodities include products such as coffee, orange juice, sugar, cocoa, and more. Softs typically refers to any commodity that can be grown instead of mined, like hard metals, and may include products listed under agricultural futures. Softs futures contracts are used by hedgers to lock in prices for raw materials used in producing consumer goods or large growers to lock in prices for a crop. Softs futures contracts are also used by speculators to take advantage of price movements in the underlying assets.
Contract specifications vary between the underlying commodities. For example, one NYMEX coffee futures contract represents 37,500 pounds of coffee.