Chapter 1-1 Futures Basics

A futures contract is a legal instrument that binds both the buyer (the holder of a “long” position) and the seller (the holder of a “short” position) to the fulfillment of certain obligations.  The buyer, barring an offsetting transaction in which the long commitment is closed out (sold), must accept delivery of the cash commodity when tendered, sometime during the delivery month for the respective future. The seller, unless he has previously closed out (bought) his short position, must deliver the cash commodity sometime during the delivery month for the respective future. Delivery is at the option of the holder of the short position with respect to the date of delivery (at any time during the delivery period), the particular grade of the cash good, and the place of delivery (subject to limitations and conditions specified by the respective exchange)

Futures contracts are heavily traded agreements between two parties to buy or sell a specified asset at a specified price on a predetermined date in the future.  The contracts themselves specify the exact quantity, quality, and type of asset that is to be bought or sold.  Futures contracts are standardized, regulated, and traded on a futures exchange.  In the United States the majority of futures trading occurs on the Chicago Mercantile Exchange (CME); the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) are additional futures exchanges.  Similar to options, futures are derivative securities- their value is derived from the expected price movements of an underlying asset.

Every futures contract has two sides to it- the buyer and the seller.  The buyer of a futures contract is looking to control his or her cost of purchasing an asset with a fluctuating price.  For example, airlines use large amounts of jet fuel.  Futures allow airlines to lock in the price they pay for jet fuel thus allowing them to better predict costs and set ticket prices more accurately.  The seller of a futures contract is looking to control his or her cost of selling an asset with a fluctuating price.  For example, futures allow corn farmers to lock in the price that they will receive for their harvest.  This allows them to predict revenues and thus begin preparing for the expenses associated with the next year’s planting.

Futures contracts are similar to options contracts in many ways.  Both are derivative securities that offer a nontraditional way for investors to expose themselves to price fluctuations of an underlying asset.  Both of these derivatives are available on a variety of assets from stocks to commodities to currencies and everything in between.  Finally, both futures and options are standardized securities that trade on exchanges just like stocks and bonds do.  This, however, marks the end of their similarities and the beginning of their extremely important differences.

The key difference between futures and options is in the settlement.  Options contracts give the holder the right to buy (call) or sell (put) the underlying asset upon expiration.  If the asset is available for a better price on the open market the option holder has the choice not to complete the transaction.  Futures contracts, however, represent the obligation to buy or sell the underlying asset upon expiration.  Both parties involved in a futures contract must complete their end of the deal regardless of the current market price.  As a result futures have different risk, cost, and payout characteristics than options.

The delivery date (sometimes called final settlement date) is the final trading day of a futures contract.  This is similar to the options expiration date.  The settlement price for a futures contract is determined at the end of trading on

the delivery date, in the case of options this price is known for the entire duration of the contract (the strike price).  There are two methods for futures contract settlement- physical delivery and cash settlement.  When futures are settled through physical delivery the contracted amount of the underlying asset is physically delivered to the futures exchange which in turn delivers the asset to the buyer of the contract.  Remember that that the seller of the contract has already been paid for the goods at a previous time.  Physical settlement is common amongst bonds and commodities, but in practice very rarely actually occurs.  Most futures contracts are zeroed out by establishing an offsetting position to avoid actually taking possession of the asset.  However, some contracts actually do undergo physical delivery; this is sometimes unintentional which has been the plotline of many humorous stories of futures traders having to purchase land to receive 100,000 cattle, or storage space for 1,000,000 barrels of crude oil.

The second form of futures contract settlement is cash settlement.  Under cash settlement a cash payment is made from one party rather than delivering the underlying asset.  The parties involved in the futures contract pay (receive) cash in the value of the loss (gain) on the position.  Cash settlement is most common of those assists that could not be practically delivered if need be.  The most common example of this occurs on stock index futures as there is no practical way to deliver the counterparty the Nikkei index.  Interest rate futures and swaps are often settled in this manner as they are abstract instruments.

Forwards are very closely related to futures contracts.  Forwards, like futures, are binding agreements between two parties to buy or sell a specific asset, on a specific date in the future, at a price agreed upon today.  The key difference between forwards and futures is that forwards are not standardized and do not trade on the open market.  Forwards are traded over the counter (OTC) and thus have different margin requirements than futures.  In general, all aspects of a futures contract that are standardized are determined on a case-by-case basis when applied to forward contracts.  This makes forwards much more customizable but also far less liquid than futures.

One of the more intricate relationships in the financial world is the one that exists between a derivative and its underlying asset.  In the case of futures, this is the relationship between the spot price of an asset and its future price.  This relationship can be described by one of two terms- contango and backwardation.  Contango is the situation in which the future price of an asset is higher than the spot price.  In essence, the futures price includes a virtual premium to compensate for holding the physical asset until maturity.  This premium operates in similarly to the time premium in an options contract and should be considered before investing.  Contango is common in non-perishable commodities such as oil; in this case the premium represents storage costs until delivery.  The opposite of contango is backwardation.  Backwardation is the situation in which the future price of an asset is lower than the spot price.  Conversely to contango, perishable commodities are often in a state of backwardation.  Backwardation exists out of the convenience factor involved in completing a spot transaction instead of a futures transaction; buying pork bellies for making bacon on the spot is a lot easier than doing so a few months in advance.

The following graphic shows how contango and backwardation relate to the spot price of an asset:

ES-futures-chapter-1-1-1

Margin

One of main appeals to the futures market is the leverage that futures contracts provide those investors.  Unlike simple equities that require a capital injection up front in order to purchase them, futures are often bought and sold on margin.  In this instance, cash only changes hands when a gain or loss is realized or the contract is held overnight (marked to market).

There are two main risks associated with the use of margin in futures contracts- counterparty risk and credit risk.  Counterparty risk is the risk born by one trader on another; it represents the risk that the other end of the futures contract won’t follow through with their obligation.  These days, counterparty risk has been mitigated by the futures clearing houses that guarantee every trade that is executed on a regulated futures exchange.  The clearing house buys from the seller and sells to the buyer, essentially taking on the risk of default from either party.

The second major risk in futures trading is credit risk.  This is the risk born by the exchange that a futures trader will not be able to pay for the futures contract itself.  For traders, this is far more relevant and carries very important implications.  To combat this risk, futures traders must post a margin, usually between 5% and 15% of the contract’s value.  Margin requirements are divided into two categories- initial margin and maintenance margin.  The initial margin is the amount of equity required to establish a futures position.  Unlike equity positions that have limited exposure based on the amount invested, the initial margin does not represent the maximum loss associated with a position.  The initial margin is simply the minimum investment required to buy a contract.  Initial margin is set but the exchange and is based on the estimated maximum daily change in the value of the contract.

The second form of margin is the maintenance margin.  This is the minimum amount of equity that a trader must maintain in his or her margin account to avoid involuntary liquidation.  When the amount of money in the account approaches the maintenance margin most brokerages will make what is called a “margin call”.  This is a warning of sorts that funds are low and the trader needs to deposit additional capital, usually enough to meet the initial margin requirements.

Consider the following examples of margin at work in a futures account:

Example 1:  E-Mini futures vs. SPY ETF

You use futures to speculate on the future value of the S&P 500 index by purchasing futures contracts:

  • Purchase 10 contracts on September 1st at 1060
  • 10% initial margin requirement requires equity of $1,060; equal to (1060 * 10 / 10)
  • Sell contracts on November 4th for 1220
  • Profit is $1,600; equal to ((1220 – 1060) * 10)
  • Return on equity is 150.94%; equal to (1600 / 1060)

This can be shown graphically:

ES-futures-chapter-1-1-2

You use an ETF to speculate on the future value of the S&P 500 index by purchasing SPY shares:

  • Purchase 10 shares on September 1st at $106
  • 100% initial investment requires equity of $1,060; equal to (1060 * 10)
  • Sell shares on November 4th for $122
  • Profit is $160; equal to ((122 – 106) * 10)
  • Return on equity is 15.1%; equal to (160 / 1060)

This can be shown graphically:

ES-futures-chapter-1-1-3

The previous example shows how futures can provide investors with increased returns on the same amount of equity invested.  Futures are derivative assets and their returns are tied to an underlying asset, in this case the S&P 500 index.  When an investor correctly identifies a trend futures can be some of the most lucrative assets available.  Unlike options that are expiring assets and thus constantly losing value, futures roll over from term to term and thus allow investors to keep more of their gains when they are realized.

Example 2:  E-Mini futures vs. SPY ETF Options

You use futures to speculate on the future value of the S&P 500 index by purchasing futures contracts:

  • Purchase 10 contracts on August 2nd at 1110
  • 10% initial margin requirement requires equity of $1,110; equal to (1100 * 10 / 10)
  • 5% minimum margin requires $555 in the account at all times to avoid margin call
  • Price decreases to 1055, margin call occurs, $555 additional investment
  • Price decreases to 1030 at the end of the month
  • Sell contracts on August 31st  for $800 loss; equal to ((1030 – 1110) * 10)
  • Return on equity is -48.19%; equal to (-800 / 1660)

This can be shown graphically:

ES-futures-chapter-1-1-4

You use options to speculate on the future value of the S&P 500 index by purchasing options of the SPY ETF:

  • Purchase 10 at the money options on August 2nd at .70
  • 100% initial investment requires equity of $700; equal to (.70 * 100 * 10)
  • Price decreases to 1040, options are at .01
  • Options expire worthless
  • Return on equity is -100%

This can be shown graphically:

ES-futures-chapter-1-1-5

The previous example illustrates the downside risk associated with futures trading.  In this instance the contracts decreased in value enough to warrant a margin call.  When this happens two things occur- you are required to transfer more funds into your account and your cost basis for the futures contracts changes.  This is significant because you are tying up more capital in one position than you initially intended, and your results will be skewed to appear more positive than they actually are.  In this case ROE is equal to approximately -50%, but when you consider the intended initial investment of $1,110 this number becomes much closer to -75%.  A straight equity position would have seen a much smaller loss, around 7%.  In this case the comparison was made to an options position to illustrate the difference between the two derivatives.  The options position realizes a maximum loss of 100% of the invested funds; however, this amount

is a lower dollar amount than the loss realized on the futures position.  Although the margin characteristics of futures contracts allow for higher returns per dollar invested, it also provides for larger loses.  For this reason it is important to understand the risks inherent with trading futures before you put any real capital to work.

Questions

  • 0

    Is this entry level training also? 

    Shawana
    Reply

    Dear Equity Scholar,I understand that this lesson is math comprehension with a future foundation to a health career in being an US trained ip transactional lawyer. by Shawana Deshon Hunter