What is a futures contract and how does it work, the pros and cons of trading on futures

A futures contract is used to make transactions for the purchase and sale of a commodity or asset in the planned future at a fixed price. This obligation is how this security differs from an option that gives the right to buy or sell, but is not forced to do so. Futures oblige both parties to the transaction to fulfill their obligations. At the same time, the material exchange of goods in the course of such trade operations is not performed.

What are futures and why they are used in the investment market

Futures contracts are used to establish the real market price for a particular instrument. They have certain applied value for investors:

1. Speculative transactions , allowing to extract material benefits.
2. Risk insurance through hedging , which is interesting for suppliers and buyers of goods.

Futures are used in commodity and commodity markets, they are characterized by the main parameters:

1. Execution time, namely the date on which the transaction is scheduled.
2. The subject of the transaction, in particular, raw materials, securities or goods, currency.
3. The exchange on which the transaction is made.
4. Quote units.
5. Margin size.

A futures contract is a risky, but also extremely liquid instrument that is not very stable. The buyer undertakes to accept the product, at the moment, not prepared for sale. However, upon the expiration of the specified period, no one can actually oblige him to purchase the goods indicated in the security, since there are no real deliveries. Futures are needed to fix the price of something, and when they expire, one of three scenarios can be implemented:

1. Preserving the balance of both parties to the contract.
2. Replenishment of balance A and decrease in balance B.
3. Replenishment of the balance of B against the background of a decrease in the balance of A.

If there is a replenishment of the buyer’s account against the background of a reduction in the seller’s account, then the value of the instrument increases. That is, investor A would be able to buy the product at a lower price and resell it at a higher price, thus extracting a material benefit. In fact, the exchange saves market participants from carrying out the necessary operations, settlements, immediately giving the party of the transaction the difference in real money. If the price has not changed, then the balance remains the same. The third scenario is realized if the price of the goods falls, which was initially beneficial to the seller. Now you can sell goods on more favorable terms, the current market price of which is less than the one that was registered in the contact. If we were talking about a real product, then the seller could buy it at market value and sell it at the price specified in the futures. Exchange, in this situation, relieves the parties from the need to transport the real goods, but simply makes the necessary calculations and replenishes the seller’s account for a certain amount, which is the difference between the market value and the price specified in the contract. If one of the parties refuses the futures before the moment of its execution, then after the expiration of the terms prescribed in the contract, the value indicated in the document and the market price of the goods are compared.

In the case of futures, buyers are required to conclude a planned transaction, and when buying an option, further actions are taken at the discretion of the investor. For example, a contract is concluded for the supply of shares, the owner of which wants to sell them in the future at a certain price. If he finds a buyer, then they conclude a contract, and the seller immediately receives the money, and the delivery will be made at the time of expiration. If we are talking about option contracts, for example, of the call option type, then the buyer expresses a desire to purchase securities, but at the moment he does not have the amount necessary for this. The seller agrees, in such a situation, to write out an option giving the right to buy shares at the time of expiration. If during this period the buyer does not decide to make a purchase, then the option is simply not exercised. However, the seller will be required to sell the securities if the buyer wants to exercise the option, which occurs when the market value of the shares has changed significantly since the contract was entered into. In this case, the transaction is made at the strike price. This difference between options and futures is leveled out if investors are dealing with deliverable contracts. In the situation with settlement contracts, the variation margin is determined daily and the fundamental difference between options and futures ceases to be felt. In this case, the seller will not be paid the market price when the transaction is completed. However, the exchange will be able to reserve certain collateral against obligations assumed by the parties. when the market value of the shares has changed significantly since the conclusion of the contract. In this case, the transaction is made at the strike price. This difference between options and futures is leveled out if investors are dealing with deliverable contracts. In the situation with settlement contracts, the variation margin is determined daily and the fundamental difference between options and futures ceases to be felt. In this case, the seller will not be paid the market price when the transaction is completed. However, the exchange will be able to reserve certain collateral against obligations assumed by the parties. when the market value of the shares has changed significantly since the conclusion of the contract. In this case, the transaction is made at the strike price. This difference between options and futures is leveled out if investors are dealing with deliverable contracts. In the situation with settlement contracts, the variation margin is determined daily and the fundamental difference between options and futures ceases to be felt. In this case, the seller will not be paid the market price when the transaction is completed. However, the exchange will be able to reserve certain collateral against obligations assumed by the parties. In the situation with settlement contracts, the variation margin is determined daily and the fundamental difference between options and futures ceases to be felt. In this case, the seller will not be paid the market price when the transaction is completed. However, the exchange will be able to reserve certain collateral against obligations assumed by the parties. In the situation with settlement contracts, the variation margin is determined daily and the fundamental difference between options and futures ceases to be felt. In this case, the seller will not be paid the market price when the transaction is completed. However, the exchange will be able to reserve certain collateral against obligations assumed by the parties.
Clearing is carried out daily, within the framework of which mutual payments of variation margin take place up to expiration. In such a situation, exercising the option becomes economically inexpedient, since it is impossible to deliver the asset at the price that was relevant at the time of the conclusion of the contract. In the value of the option, with such a development of events, there is always a temporary premium that is lost with the onset of expiration. Execution of the option will not affect the account balance, and the option will be replaced by a future in the terminal. Futures expiration – what happens to the position: https://youtu.be/QQjRRxXZP3Y

Differences between futures and forward contracts

There are also differences between forward and futures contracts that investors enter into. A forward is a one-time transaction made outside the exchanges and assuming that the purchase of a commodity, securities or currency will take place in the future. The parties discuss the main conditions in advance:

• price;
• terms;
• additional conditions.

In this case, the transaction is carried out with real assets, and not as with futures, when we are not talking about the transfer of goods.

The forward is designed to insure the participants in the transaction against price fluctuations that are likely to occur in the future. There are no strict standards when concluding a contract, therefore, such transactions cannot be carried out on the exchange.

Forward and futures contracts differ from each other in the following aspects:

• goals – the forward will be concluded for the sale or purchase of real assets, which implies the consideration of all conditions that are beneficial to both parties. In the second case, futures contracts are hedging their own positions or benefiting from price differences. Futures only in 5% of cases lead the parties to the exchange of real goods or financial instruments;
• volume of the asset – when concluding a forward contract, the participants in the transaction independently calculate the required volume, taking into account their needs. In the case of futures, the volumes are determined by the exchange, and market participants have the right to implement a certain number of contracts;
• quality of instruments – forward provides an opportunity to use assets of any quality, depending on what requests come from the buyer. When it comes to futures, the quality of the instruments is determined by the specification of the exchange;
• delivery of goods – when signing a forward, assets are always delivered, and when concluding a futures delivery is carried out in the form established by the exchange, but in most cases it does not come to this at all;
• terms – the terms of delivery when signing the forward are determined by the parties to the transaction. The terms of futures contracts are determined by the exchange;
• liquidity – a forward contract is characterized by limited liquidity, since the terms of its conclusion are acceptable for a certain circle of counterparties between which it was concluded. Futures are highly liquid instruments, however, the level of this indicator depends on the quality of the underlying asset.

Traders can open short and long positions when trading futures contracts. This technique involves the purchase of a contract for the supply of a certain asset and, in the event of an increase in the value of the futures, sells it even before the expiration of the contract. Working with short positions is to sell futures in case of unfavorable developments. If the situation improves later, he buys the contract back, but at a lower cost, earning on the difference in price. The futures will move in sync with the underlying asset, however, there is some difference between them, leveling as expiration approaches.

What are futures and how to trade on the derivatives market of the Moscow Exchange – strategies for trading on futures contracts: https:/ /youtu.be/ZDg14Rya6LI

Pros and cons of futures trading

There are several advantages of futures trading:

• no additional costs and hidden fees;
• there is access to a pool of futures with an expiration for a year;
• high liquidity of the asset, volatility and dynamic trading.

Disadvantages of trading futures contracts:

• not suitable for long-term trading, as it is valid for a certain time;
• when expiration occurs, deals are closed automatically, taking into account the current market price and pending orders are deleted;
• you cannot transfer open trades to a contract expiring next month.

Weigh all the pros and cons before trading these highly risky instruments.

Types of futures contracts

There are two types of futures contracts:

1. Delivery.
2. Settlement – without deliveries.

Deliverable futures oblige the buyer and seller to actually sell the goods and pay for them within the terms specified in the contract. The settlement between them is carried out at the price that was fixed on the last day of trading. If, with the due date, the seller was unable to provide the buyer with the goods, then the exchange imposes penalties on him.
Estimatedfutures is in no way connected with the actual supply of products. It is assumed that one of the parties will pay the other party to the transaction the difference between the value of the asset at the time of the transaction and the actual price of the product at the time of the contract expiration. The settlement between counterparties is made in money, and the physical delivery of goods is not provided. Such transactions are made for hedging or speculative manipulation. Hedging allows you to level the probable losses received when concluding a contract in another market.

Futures contract price – contango and backwardation

A futures contract is categorized as a single exchange commodity, with a value different from the price of the asset. This indicator may be affected by forecasts and risks caused by a likely change in the subject of previously reached agreements. The price of an asset in the market and the futures price of this commodity can have a negative or positive ratio.

If the contract is more expensive than the asset, then this state is called contango. In the case when the situation is reversed, we are talking about backwardation.

In this situation, most investors hope that the price of the asset on the exchanges will soon drop significantly.

The price of a futures is the current market value of a contract that has a certain expiration date. Fair price is defined as the cost to acquire an asset that will be delivered immediately and then hold it, through to use, through profit-making, sale or use. At the same time, at a fair price, it is profitable for a trader to purchase a contract for an asset with a certain maturity date. The difference between the corresponding and the current price is called the basis of the contract, which is in two states relative to the spot price of the asset.

Insurance

Trading is carried out subject to the provision of a transaction, through a deposit, the amount of which is 2 – 10% of the price of the contract asset. This is the insurance required by the exchange from both parties entering into the contract. The set amount is blocked on the accounts, forming a kind of collateral. If the price of the futures goes up, then the seller’s margin increases, and if it goes down, it decreases. This mechanism allows you to avoid the payment procedure when concluding a contract. When a future is held until it closes, the parties fulfill their obligations by delivering assets or transferring cash. When one of the participants does not want to fulfill his obligations, the exchange does it for him, leaving himself a certain amount from the guarantee. This scheme only works for contracts that provide for the delivery of an asset.

Expiry dates

There are several contract expiration dates. For example, for the dollar index, stocks, financial instruments, the expiration date is quarterly on the third Friday of the last month of the quarter. There are futures with a monthly exit, in particular CME Crude Oil. Other types of contracts may end on other days. To trade futures productively, you should remember the expiration date of the contract. If there is an unexpected decrease in volume after the expiration of the next day of trading, then the timing is right, and most traders begin to close transactions before the termination of the contract.

Each futures contract has an expiration date. Check the contract specifications for the expiration dates of your contract. There is usually a significant drop in volume as the futures contract arrives within a few days of its expiration. This is because all short-term traders close their positions and only people and companies who want to buy or sell the underlying product continue to trade and hold their positions until the expiration date. Short-term traders do not enter into futures contracts before expiration, they simply make or lose money based on price fluctuations that occur after buying or shortening a contract.