Many investors portfolios today include securities
such as equity, bonds and mutual funds, however, there are
a vast number of financial instruments that exist in the
investment world which are far more complex in nature. One
such instrument is the futures contract, or simply futures.
So what exactly is a futures contract? A futures contract
is an agreement between two parties to buy or sell financial
instruments or physical commodities for future delivery,
at a specified price.
A simple example will illustrate. Lets assume you
decide to subscribe to your favourite magazine. To do so,
you agree to pay the publishing company a certain price
(annual subscription fee) to receive the magazine every
month for the next year. This is similar to a futures contract
in that the price and delivery terms are defined today,
for a product you will receive in the future. By so doing,
you reduce your risk of higher subscription prices by locking
in the current annual subscription fee today.
In the same manner, a farmer and a flour producer may enter
into a futures contract entailing delivery of 5,000 bushels
of wheat in six months time at an agreed upon price of $10
a bushel. This contract is what can be bought and sold in
the futures market.
Note that in every futures contract there exists two parties
or positions: a short position and a long position. The
participant agreeing to sell or deliver a commodity is the
holder of the short position while the participant agreeing
to buy or receive a commodity is the holder of the long
position. Therefore, in our example above, the farmer would
be in the short position and the flour producer the holder
of the long position.
While trading in commodities began in Japan in the 18th
century with the trading of rice and silk, today, there
are many different commodity exchanges worldwide to include
the trading of various products, a few of which are listed
Futures contracts are highly standardised by specifying
all of the contract details such as: the underlying asset
or financial instrument, the contract size and the specific
price per unit, the grade or quality of the commodity, the
type of settlement whether cash-settled or physical delivery,
the minimum price movement also known as the commodity tick,
the daily price limit and the last trading date.
Lets take a closer look at the commodity tick and
daily price limit and how they can affect the profits and
losses on contracts.
As previously mentioned the minimum permissible amount that
the price increment on a futures contract can move, upwards
or downwards, is known as the tick. These minimums are set
by the futures exchanges and are important because they
determine how much can be gained or lost on a particular
contract in one day. Lets assume that you had a wheat
futures contract for 5,000 bushels and that the tick size
for wheat futures was a quarter of one US cent per bushel.
This would mean that a minimum of US$12.50 ($0.0025 x 5,000)
could be gained or lost on this contract in one day.
It is possible that the price on a futures contract can
The daily price limit determines the boundaries between
which the futures contracts can trade for the day and are
set by the futures exchanges. These upper and lower price
limits are calculated by adding the daily price limit to
and subtracting the daily price limit from the previous
days settlement price. Thus, if wheat closed yesterday
at $10 a bushel and there is a daily price limit on wheat
of 30 cents a bushel, todays upper price boundary
would be $10.30 and the lower boundary would be $9.70.
Also, during the course of the day if the price of the futures
contracts for the underlying commodity reaches either of
the boundaries, the exchange shuts down trading of all futures
contracts for that commodity for the day.
Every day the profits and losses of a futures contract are
calculated based on the price movements of the market for
that contract in that day. Using the farmer and flour producer
example previously mentioned, lets say that wheat
futures increased from $10 to $12 a bushel the day after
the farmer and flour producer entered their futures contract.
The farmer would have lost $2 a bushel, as the selling price
had increased from his negotiated price. The farmers
account would be debited $10,000 ($2 a bushel x 5,000 bushels)
on the day of the price change.
Likewise, the flour producer has made a profit as he is
paying less than what the market was required to pay for
wheat futures. The flour producers account would be
credited by $10,000. The fact that futures are marked to
market or rebalanced daily is what makes futures attractive
as there is no credit risk associated in trading futures.
If, at any time, the current market value causes the traders
margin account to fall below the maintenance margin, a margin
call will be made to the futures trader.
On the settlement date of the contract, the holder of the
short position (seller) delivers the commodity to the holder
of the long position (buyer). If it is a cash-settled future
the funds are transferred from the futures trader who incurred
the loss to the one who made the profit.
In most cases, however, physical delivery of the commodity
never takes place.
Prior to the delivery day, holders of a futures position
are informed that they must close out their position or
accept delivery and pay any contract obligations.
So, who participates in this market? Futures traders generally
fall into two categories: hedgers and speculators. Hedgers
commonly use futures to protect against adverse future price
movements in the underlying commodity. Producers and consumers
of a commodity, farmers and manufacturers, would fall into
this category. Speculators, on the other hand, do not seek
to minimise risk but rather to make a profit through the
buying and selling of futures contracts. They seek out the
very same price risk that hedgers avert.
As the futures market is a centralised marketplace for traders
from around the world it provides very important market
information. This information is what affects the prices
of commodities in the futures market.
Factors such as war, supply concerns, weather and deforestation
all have a major consequence on the amount of supply and
demand, which in turn affects the current and future price
of a commodity. For this reason, the futures market has
also become a vital economic tool.
Futures market is not for the faint hearted and should only
be entered into if you have a great understanding of the
market and how it functions. Speculators entering the futures
market should be wary as it is very risky and only funds
put aside as risk capital should be invested in this market.
West Indies Stockbrokers Ltd (WISE)