Futures Characteristics
A long (short) futures position obligates the owner to buy (sell) the underlying asset at a specified price and date. Most futures positions are reversed (or closed out) as opposed to satisfying the contract by making (or taking) delivery.
Futures/Spot Convergence
The spot price of a commodity or financial asset is the price for immediate delivery. The futures price is the price today for delivery at some future point in time (i.e., the maturity date). The basis is the difference between the spot price and the futures price. As the maturity date nears, the basis converges toward zero. Arbitrage will force the spot and futures prices to be the same at contract expiration.
Margin Requirements
Futures are traded on margin (leveraged):
- Initial margin is the necessary collateral to trade the futures.
- Maintenance margin is the minimum collateral amount required to retain trading privileges.
- Variation margin is the collateral amount that must be deposited to replenish the margin account back to the initial margin.
The futures market is a zero-sum game in that the short’s losses are the long’s gains and vice versa. Gains and losses due to changes in futures prices are computed at the end of each trading day in a process known as marking to market.
Clearinghouses in Futures Transactions
The clearinghouse maintains an orderly and liquid market by acting as the counterparty to each long or short futures position. In the over-the-counter (OTC) markets, the central counterparty (i.e., clearinghouse) becomes the counterparty to both parties in an OTC transaction.
Central Counterparties in Over-the-Counter Transactions
Historically, OTC markets functioned as a series of bilateral agreements between parties through a process known as bilateral clearing. Regulators have pushed for the use of centralized clearing in OTC markets through the use of central counterparties (CCPs) in an attempt to reduce systemic risk. CCPs operate in a similar fashion to clearinghouses on futures exchanges.
Collateralization is a means of reducing credit risk in bilateral OTC contracts. It is a marked-to-market feature where any loss is settled in cash at the end of the trading day. A cash payment is made to the counterparty with a positive account balance.
Futures Market Quotes
Increasing settlement prices over time indicate a normal market, while decreasing settlement prices over time indicate an inverted market.
Futures quotes can be found from exchanges as well as various online sources. Quotes typically contain the last trading price, the previous day’s settlement price, and the open, high, and low prices for a particular trading day. The settlement price is typically computed as the price right before the end of the previous trading day The quote would also include the trading volume of each futures contract, which indicates the number of contracts that have been traded on a given day.
The Delivery Process
A short can terminate the futures contract by delivering the goods. When the long accepts this delivery, he pays the contract price to the short. This is known as the delivery process. In a cash-settlement contract, delivery is not an option.
Types of Trading Orders
Several different types of orders exist in the marketplace including: market, limit, stop-loss, stop-limit, and market-if-touched orders. Market orders are orders to buy or sell at the best price available. Limit orders are orders to buy or sell away from the current market price. Stop-loss orders are used to prevent losses or to protect profits. Stop-limit orders are a combination of a stop and limit order. Market-if-touched orders are orders that would become market orders once a specified price is reached.
Forwards and Futures Contracts
Futures contracts are similar to forward contracts in that both allow for a transaction to take place at a future date at a price agreed upon today. The difference between the two is that forward contracts are private, customized contracts, while futures trade on an organized exchange and have terms that are highly standardized.
