Futures are financial instruments that obligate the seller of the futures contract to sell the underlying asset and the buyer of the futures contract to buy that underlying asset at the contract price and date.
Futures specify the quality and quantity of the underlying asset to be traded, though many futures come with a clause that allows for cash settlement.
Futures in Contemporary Markets
While futures were originally used for the physical settlement of traded commodities, they are now a widely used derivative product in almost every area of the contemporary markets.
The market for futures and options (another form of derivatives contract) are occasionally many times larger by value than the market for the actual physical delivery of the underlying asset.
For example, the market for oil futures has been 30 times larger than the market for the physical delivery of oil on some days.
They are used for both speculation and hedging, as interested parties can make trades based on the future direction of prices.
Speculators use futures to trade in areas of the markets that they may otherwise have no access to. The trading of physical oil or large amounts of gold, as examples, is generally limited to a small number of institutions, whereas most retail traders have access to futures trading.
The option for cash settlement means that investors without storage capacity can make trades in most commodities, and that intangible objects, such as the VIX index, can be traded easily and securely. Futures with a physical delivery option, however, can carry added costs for the physical storage of the underlying asset.
Most futures are traded on margin, which allows speculators to make leveraged trades in markets where they may otherwise be unable to.
Most hedging using futures, by contrast, is not intended as a wager on the direction of the price as speculation, but rather as a form of insurance in the case of undesirable changes in price.
This can include both directional changes and an increase in the overall volatility of the price. They allow related producers to hedge their profits as they are affected by the underlying asset, which can be both to cover against profit reductions or to smooth the flow of profit between different periods of time.
The Difference Between Futures and Options
Futures and options are both derivatives contracts that are based on the performance of an underlying asset. While they share many similarities, they also feature key differences that makes their use ideal for different situations.
The primary difference is that futures require the contract to be settled, whereas options only give the right but not obligation for settlement to the owner.
The main secondary difference is that options are bought with an unleveraged premium, though the seller of an option can also do so on margin, similar to a futures contract.
Day trading futures is generally intuitive, and a good place for day traders to expand into more complex and exotic securities. They also come with the added benefit of being traded on margin, if cleared by your broker, which allows for leveraged trades that can dramatically increase profits.
The use of futures is now so widespread that futures in different markets can have significantly different behaviors. It is critical for day traders to fully understand each futures market they intend to trade in before they begin to trade.
Different futures contracts and exchanges also have different rules and regulations for settlement and storage. Traders need to ensure that they fully understand the rules governing the contracts they are trading before they begin trading.
They are used by large institutional investors who expect quick and efficient contract clearing, particularly when that involves a physical settlement.
Futures are a transformative form of derivatives contract that have revolutionized the commodity sector of the markets and more.
They represent a broad range of trading possibilities for day traders, and do not require the same mathematical skills as options.
However, it does come with some added complexity, and day traders should be sure to understand the nature and the rules of any futures contracts before they begin trading them.
Photo: WASHINGTON, DC – AUGUST 20: Emblem at the U.S. Commodity Futures Trading Commission in Washington, DC on August 20, 2017.