What Are Futures?
Futures are financial contracts that allow two parties to agree on the price of an asset today, with the transaction taking place at a specified date in the future.
Although the concept may initially seem complicated, it is built on a simple idea: locking in a price now to reduce uncertainty later, or to take advantage of expected price changes.
How They Work
A futures contract always involves a buyer and a seller. The buyer agrees to purchase an asset at a future date, while the seller agrees to provide that asset at the agreed-upon price.
These contracts cover a wide range of underlying assets. Traditionally, futures were associated with physical commodities such as oil, gold, wheat, and coffee. However, modern futures markets also include financial instruments like stock indices, interest rates, and currencies.
What They Are Designed to Do
One of the primary reasons futures exist is to help manage risk, a practice known as hedging.
Businesses and producers often face uncertainty due to fluctuating prices. For example, consider a wheat farmer who expects to harvest crops in a few months. If the market price of wheat drops by the time the harvest is ready, the farmer could face significant financial loss.
To avoid this risk, the farmer can enter into a futures contract to sell wheat at a fixed price in the future. This ensures a predictable income regardless of market conditions.
Similarly, companies that rely on raw materials can use futures to protect themselves from rising prices.
A bread manufacturer, for instance, might purchase wheat futures to guarantee a set price for future supply. By doing so, the company can better plan its costs and avoid sudden increases in expenses. In both cases, futures provide stability and reduce the uncertainty associated with price volatility.
Playing the Market
In addition to hedging, futures are widely used for speculation. Speculators are traders who aim to profit from price movements rather than actually buying or selling the underlying asset.
For example, if a trader believes that the price of oil will rise in the coming weeks, they may buy a futures contract at the current price. If the price does increase, they can sell the contract at a higher price and make a profit.
Conversely, if they expect prices to fall, they can sell futures contracts first and buy them back later at a lower price.
Speculation adds liquidity to the market, making it easier for hedgers to enter and exit positions. However, it also introduces risk, as price predictions can be incorrect. Losses can accumulate quickly, especially due to the use of leverage in futures trading.
Where to Find Them
Futures contracts are typically traded on organised exchanges, which play a crucial role in maintaining fairness and efficiency.
These exchanges standardise key aspects of each contract, such as the quantity and quality of the asset, as well as the delivery date. This standardisation allows traders to easily buy and sell contracts without negotiating individual terms each time.
Another important feature of futures trading is the use of margin. Unlike traditional purchases, where the full amount is paid up front, futures traders only need to deposit a small percentage of the contract’s value. This deposit is known as the initial margin.
The exchange then adjusts the trader’s account daily based on changes in the market price, in a process called marking to market. If the market moves against a trader’s position, they may be required to add more funds to maintain their position, known as a margin call.
Leverage is closely related to margin and is a defining characteristic of futures markets. Because traders control large contract values with relatively small amounts of capital, potential profits can be significant. However, this also means that losses can exceed the initial investment if the market moves unfavourably.
As a result, futures trading can be highly risky and requires careful management.
Most Contracts Do Not End with Physical Delivery
It is also worth noting that most futures contracts do not result in the actual delivery of the underlying asset. Instead, traders usually close out their positions before the contract’s expiration date.
This is done by taking an opposite position – selling a contract if they originally bought one, or buying if they originally sold. This process allows traders to realise gains or losses without dealing with physical goods.
Conclusion: Swings and Roundabouts
Futures are versatile financial instruments that serve two main purposes: managing risk and enabling speculation. They help businesses stabilise costs and revenues while providing opportunities for traders to profit from market movements.
By standardising contracts and using systems like margin and daily settlement, futures exchanges ensure that trading remains efficient and secure. However, due to the presence of leverage and market volatility, futures require a strong understanding and disciplined approach.
For anyone entering this market, it is essential to fully grasp both the benefits and the risks involved.
WRITTEN BY STEVEN JONES
Steven Jones is a retired tax practitioner and member of the South African Institute of Professional Accountants.
While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither writers of articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.