How Does The Futures Market Work?
As the name implies, the futures market considers the value of assets in the future. Investors in this market seek to capitalize on volatility by limiting it. Moreover, investors make money through futures contracts. These contracts set the price of assets between buyers and sellers and allow investors to profit the difference when economic conditions drive up the price. Investors then trade these contracts within the futures market.
It’s best to think of the futures market as an auction market. It’s also a derivative market, since no assets actually exchange hands. What makes the futures market unique is that it’s overlaid on the broader financial markets. Anywhere there’s asset exchange, there’s opportunity for futures contracts.
What Are Futures?
Future contracts guarantee stability. They protect buyers and sellers from price fluctuations by locking in the price of commodities. A third-party investor negotiates contracts with buyers and sellers to stipulate prices. The investor then assumes all risk and reward through the futures contract. For example:
A farmer sells wheat for $5 per bushel to a baker. To avoid volatility that comes with price increases or decreases, the farmer and the baker lock in this $5 price with an investor. Both parties are protected against price inequality, and the investor reaps the benefit of any extraneous profits.
Futures contracts are available for any fungible asset that appreciates or depreciates in price. Regardless of the asset, their purpose remains the same. Futures are a hedge against volatility for buyers and sellers and an opportunity for profit among brokers.
Types of Futures
Because futures are a derivative investment, they’re rooted in the exchange of fungible assets. While they’re most often associated with commodities, there are also futures for currency, stocks, bonds and precious metals. Some of the most commonly traded futures include:
- Commodity futures, which crude oil, natural gas and agriculture products
- Currency futures, leveraged against the exchange rate of currency pairs
- Stock index futures, including for the S&P 500 and DOW Jones Industrial Average
- Treasury futures, pertaining to bonds and other investment-grade debt products
- Precious metal futures, specifically for gold and silver
It’s important not to confuse options and futures. Options give investors the right to buy and sell assets at a certain date. Futures guarantee the price of assets at an agreed-upon price point. Moreover, investors exercise options on the fungible asset, whereas futures are a derivative.
How to Buy, Sell And Trade Futures
Clearinghouses such as the Chicago Mercantile Exchange control futures contracts. This is where investors can buy or sell futures contracts. Purchasing a futures contract entitles the holder to the profitability of that contract. However, it also opens them up to the risk. Investors buy and sell futures contracts through the clearinghouse when they believe they’re in the best position to profit from certain assets.
For example, if Jim believes there’s going to be a global shortage of coffee beans, he might buy a futures contract for them. If the cost of beans rises, he can profit the difference through the value of his contract. Then, he can sell the contract before supply and demand rebalance. Unfortunately, if Jim’s assumption is wrong and there’s a surplus of coffee beans, he’ll lose money on his futures contract.
There’s also the prospect of arbitrage in the futures market. Typically, this means cash-and-carry arbitrage. It only occurs in the event of mispriced commodities or price discrepancies across brokers.
The futures market is heavily rooted in commodities because these assets have global risk exposure. There’s more demand for price certainty from buyers and sellers, and more opportunity to profit from futures contracts from investors.
Because futures aren’t subject to the pattern day trading rule, they’re a more active market. It also helps that futures trade 24-hours-a-day.
Key Futures Market Terms to Know
Like most derivatives, the futures market is a very complex market. It requires deep familiarization with certain terms and phrases. Investors buying or selling futures contracts need to understand the verbiage that goes along with it. Here are a few of the most basic, common terms:
- Arbitrage: The act of buying and selling simultaneously, to profit on price difference.
- Clearinghouse: The brokerage in charge of executing on futures contracts.
- Commodity: A tangible good that’s bought and sold. The basis for a futures contract.
- Contract: The agreement that locks in the price of the asset being bought and sold.
- Hedging: When commodity producers buy a futures contract against their own good.
- Leverage: Buying a futures contract on margin, putting up a fraction of the value.
- Speculation: The hypothesis of investors as to whether a commodity will rise or fall.
There are many, many terms associated with trading futures. It’s important to not only understand the broad terms, but also those associated with the types of contracts you’re trading.
The Basic Functions of The Futures Market
As mentioned, the function of the futures market is to protect buyers and sellers from volatility. Its secondary purpose is to help investors capitalize on this volatility. Investors who assume the risk-reward of a futures contact safeguard buyers and sellers from price swings while making a profit. Likewise, buyers and sellers can mitigate risk to their business and continue relatively cost-efficient relationships.
Futures contracts can be complex. So, it’s important to do your research. Sign up for the Wealthy Retirement e-letter below. This daily newsletter does the research for you and also provides various stock tips and retirement strategies!
It’s best to think of the futures market as one big hedge. Derivatives mitigate risk where appropriate and create opportunity out of volatility.