An Overview of Futures

In a rare moment of quiet on an often raucous Chicago trading floor in 1870, a wheat farmer walks over torn-up sheets of paper to approach a trader to hand over a proposition. The farmer offers to deliver 5,000 bushels of wheat in three months for a guarantee of $1.05 a bushel rather than wait until the harvest to sell when prices might have gone down. The trader takes on the risk, betting prices will rise to about that, making a good deal of profit in return. Hands shake, and an early form of a futures contract is born. Nearly 150 years later, futures and their offspring—options, swaps, and other byproducts—make up a fast-growing, complex, and global market connecting producers, investors, speculators, and consumers worldwide. According to the Futures Industry Association, the number of futures traded worldwide more than doubled to 29.2 billion in 2023 from 12.1 billion in 2013. Now popular among ordinary investors, these agreements affect the prices we pay for food, fuel, and most raw materials that support modern life.

Futures contracts are standardized agreements traders enter to buy or sell an asset at a specified price on a future predetermined date. They were originally used to hedge against price shifts for crops and other commodities by guaranteeing a fixed price. Futures still serve that purpose. But speculators also trade futures, wagering on which way prices will move. Below, we take you through how futures contracts work, what types there are, who trades them, how they are regulated, and the risks and rewards of in trading them.

How Futures Contracts Work

Standardization has been crucial for the operation of futures markets. Futures are traded on centralized exchanges like the Chicago Mercantile Exchange (CME), which lists what's available and sets the specs for the products and contracts. Investors generally don't have direct access to exchanges and instead place futures orders through brokers, instead of relying on getting money back from a single trader, whom you might not wholly trust, clearinghouses partner with exchanges to cover the trades automatically. By establishing terms, reviewing brokers, partnering with clearing firms, and setting margin requirements, futures exchanges make trading orderly while mitigating the risk of default.

Futures contracts detail the asset quality, quantity, delivery timeline, and other specifications to aid trading. For example, a single corn futures contract represents 5,000 bushels of grain meeting defined grade standards to be delivered in a given month. Prices are based on the underlying asset's value, supply and demand, and their predictions about future prices. If you're agreeing to buy a future, you're said to be long; if you're agreeing to sell, you're the short.

When entering a contract, you must post at least an initial margin. These deposits act as collateral, with the amount based on the number and type of futures contract. Here's a quick look at the process of buying futures:

1. Open an account: If you haven't already, you'll open a futures trading account by applying to a registered futures brokerage. The required minimum balance and settlement process will depend on the firm.
2. Look for prospects: You'll next browse prospective futures contracts on exchange listings.
3. Submit your order: You'll then put in your order through the brokerage platform, specifying the month of expiration and the price you're bidding. If the order matches an active counterparty, the trade executes instantly.
4. Monitor your contracts: Log in daily to track the changing value of your futures contract and manage the required margin levels. If it looks like you're starting to take a significant loss, your initial margin may not be enough, so your broker could issue a "margin call" to deposit more funds to maintain your position.
5. Closing out: To exit an open futures contract, you'll execute what's known as an offsetting trade, reversing the initial action taken to enter the position. If you're using an online platform, the interface should indicate your open positions and make offset closing simple with prepopulated order screens.
6. After exiting: Once you execute the offsetting trade, any profits or losses accumulated are immediately realized, credited, or debited from your account balance. This settles the trade.
   

Types of Futures Contracts

In the first quarter of 2024, the most traded futures were in equities (65% of futures trading by volume), currencies (9%), interest rates (9%), energy (5%), agriculture (4%), and metals (4%). Let's review the types of futures contracts:

Agriculture futures: Agricultural commodities are the underlying asset for the oldest kinds of these contracts, which corn, soybeans, and wheat. They have long been used to hedge prices against too much (for farmers) and too little (for companies and resellers) supply.

Currency futures: FX futures allow speculating on global currency shifts. The most popular currency futures trade on the value of the dollar, euro, yen, and pound and are useful for multinationals managing cross-border operations.

Cryptocurrency futures: Introduced in late 2017, Bitcoin futures rode the crypto craze to prominence, giving investors exposure to this volatile market.

Energy futures: From heating oil distributors to electric utilities, energy futures enable those up and down the supply chains to keep prices stable through unpredictable geopolitical turmoil, outages, and demand spikes from harsh weather.

Equity futures: Almost two-thirds of trading in futures is on equities, which allow you to hedge or speculate on individual company share prices. Equity futures are often used around corporate events like earnings reports, mergers, or other potential catalysts for changes in share prices.

Freight futures: These offer a way for producers, exporters, and shippers to hedge against volatile ocean cargo shipping rates. Freight futures track bulk carrier spot price indexes for established global transport routes.

Index futures: Futures for indexes like the S&P 500 and Nasdaq have been used to speculate on broader stock market movements or hedge investment portfolios against declines. Mini-index futures, like the E-mini S&P 500 priced at $50 times the value of the index have proven very popular with retail investors.

Interest rate futures: These are based on benchmarks like Fed funds rates, Eurodollars, Treasurys, and bonds, letting you speculate or hedge against changes in interest rates. Broadly speaking, as interest rates rise, bond prices typically fall, and vice versa. Investors, fund managers, and financial institutions use interest rate futures to protect their portfolios against interest rate changes or to take positions based on their interest rate outlook.

Metal futures: Futures on precious and industrial metals offer miners, manufacturers, and speculators vehicles to ride out price volatility. Gold and silver futures, in particular, attract those seeking safe harbor from broader market uncertainty.

Participants in the Futures Market

Futures markets enable parties to hedge, speculate, or perform price discovery and delivery all through a standardized mechanism. Those participating in the futures market range from producers and consumers managing risk to speculators and firms placing sophisticated bets. Below is a table identifying the major types and the trading involved.

Here are the specific kinds of market participants:

Commercial Hedgers

Companies across different sectors use futures to hedge pricing risks inherent in their operations, locking in costs for essential raw materials from agriculture to metals to energy. Without securing future supply prices, volatility could paralyze the ability to make budgets. For example, agricultural companies might want to lock in prices for this year's harvest, or airlines will choose a set jet fuel price since oil prices can be volatile.

Hedge Funds

Given their substantial capital and ability to trade as they wish, hedge funds are influential speculative futures traders. They often carry out long and short strategies, simultaneously buying and selling related derivatives to capitalize on temporary price discrepancies. Their outsized trading volumes give hedge funds the power to move markets.

Proprietary Trading Firms

These speculative powerhouses trade their capital with algorithmic trading, often at lightning speed. Prop shops leverage sophisticated technologies and quantitative strategies for fleeting market inefficiency.

Retail Traders

Individual investors have also grown active in futures, enabled by user-friendly online brokerages. Drawn by margin-fueled leverage allowing outsized gains (and losses), retail investors add liquidity while trying to profit from short-term fluctuations. Their numbers and appetite for risk continue to swell. A 2024 study by economists at the Commodity Futures Trading Commission (CFTC) concluded that, in general, "retail traders lose money in futures markets."

Risks and Rewards of Futures Trading

Futures prices can turn on a dime, rapidly sinking even the most seasoned investors. Without prudent safeguards like stop-loss orders that trigger automatic sell-offs before additional losses and the self-discipline to avoid recklessly large gambles, futures traders can court ruin.

Unlike other assets, futures require less capital upfront. Contracts carry built-in leverage. With a relatively small deposit (25% or more), you can control whole shares or physical commodities. This allows you to buy futures with less capital. But this cuts both ways: losses accumulate quickly when the market swings against you.

Yet futures ultimately offer defined, manageable risks if utilized responsibly. By understanding the risk-reward relationship in futures, you can weigh how to trade in them more appropriately.

Futures vs. Other Financial Instruments

While they have commonalities with other derivatives and financial securities, futures contracts have a distinct purpose, and their differences need to be well understood.

Futures vs. equities: Futures represent contracts over company shares, not legal equity ownership. Their built-in leverage provides greater relative exposure for less upfront capital.

Futures vs forwards: Forwards are the older of these contract types, going back to ancient forms of trading, later evolving into futures. Both involve contracting for the delivery of a future asset. However, futures have standardized terms, trade on exchanges, and require collateral. Forwards are still often traded but are over-the-counter, customizable agreements.

Futures vs. options: Options grant buyers the right but not the obligation to the underlying asset. You can exercise an option or let it expire worthless. Futures come with the commitment to make later trades or payments. Hence, they are generally riskier than options.

Regulation and Oversight of Futures Trading

The CFTC, an independent federal agency, is the U.S.'s primary regulator for futures trading. The CFTC establishes rules, monitors market activity, and enforces regulations to prevent manipulation and ensure a fair and transparent marketplace.

Main areas of Futures Oversight

The CFTC sets rules for how contracts are traded, including requirements for margin deposits and limits on excessive speculation that would artificially distort prices. In addition, clearinghouses, the exchange partners guaranteeing each futures trade, must meet CFTC risk management standards so the market remains stable. The CFTC also mandates transparency and reporting requirements, including detailed records of large trades and market positions.

Beyond the CFTC

Futures exchanges, such as the CME and NYMEX, maintain their own internal rules and surveillance mechanisms. The National Futures Association, a self-regulating body, complements the CFTC's work by overseeing individual brokers and firms.

Ongoing Challenges for Futures Trading

The sheer volume of trades and the complexity of modern financial products, including cryptocurrency futures, make oversight challenging. Regulations aim to smooth violent price swings, but balancing market fluidity remains tricky. The outsized market footprint of large institutional investors like hedge funds, along with ultrafast computerized trading, injects systemic fragility.

The fact that the markets are global adds further complexity since international coordination is necessary to prevent traders from exploiting regulatory gaps. Finally, the CFTC, like any government agency, is subject to lobbying and political pressure, and regulators often face pushback from industry players who chafe at many regulations meant to protect investors and consumers.

The Bottom Line

Futures can be a great vehicle for hedging and managing risk; they enhance liquidity and price discovery. Market participants can hedge against unfavorable market shifts or speculate to profit from price volatility in a wide range of commodities and securities. However, futures are complicated instruments, and one should understand them well before trading.