Futures

What are Futures and what are they used for ?

Futures contracts are used by producers and industrial companies to ensure or lock prices in the future. Let us assume you are a producer of breakfast cereals and you have a long term contract with asupermarket chain. As a producer you are interested to keep your prices on a constant level to avoid to rise in prices in the future. For this reason you can buy a corn Futures contract today with the price of 353 bp for 5.000 bushels (~ 127 Metric Tons), for example with a delivery date of August 2017, March 2018, August 2018 ... As you buy the contracts and the corn now with a delivery date in the future you lock the prices now and this gives you security for your future planning and allows you to keep stable prices for your customers.

It is the same for the farmer or producer. They have an interest to fix prices for future products now, too. Let us assume we have a farm and we plan what to seed for the next year. If we do not know at what price we can sell our products it brings danger to us. It would be possible that we seed corn and that the corn prices are down at the time we want to harvest the corn and sell it. Maybe we better seed soybean or other crops? With a future contract we can sell the crops at the moment we seed it and we can be sure for what price we sell it later on. For example we sell a corn futures contract with a delivery date of August 2018 with 5.000 bushels now for 353 bp. This gives us security for our planing now because we can be sure how much money we get in August 2018. The same is true for Gold producers, they can plan their mining activity or Oil producers and all other kind of producers.

Speculators play another important role in the Futures market. The producer and the industrial company only want to buy or sell Futures contracts to a specific point of time, for example when they harvest their field or when they plan to produce or stock their depots. If all farmers harvest corn in mid-September and sell their corn the price goes down as the supply overexeeds demand. This is where the speculator comes in and acts as buyer for the seller (the farmer) and as seller for the buyer (the industrial producer). The speculator helps to ensure an ongoing supply of commodities, without the speculator it would not be possible for the farmer or industrial producer to run their business.

A futures contract is a standardized forward contract which can be easily traded between parties other than the two initial parties to the contract. The parties initially agree to buy and sell an asset for a price agreed upon today (the forward price) with delivery and payment occurring at a future point, the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product (LINK https://en.wikipedia.org/wiki/Futures_contract ).

Exchange traded Futures are highly regulated and liquid. They contain -due to a system of insurance and reassurance- a smaller counterpart risk than many other investment categories. Even through the great repression from mid-1929 to mid-1931 there was no issue with the delivery of Futures contracts.

All Futures have an expiry date on which the position needs to be closed or the commodity needs to be delivered or bought. Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. To hold a commodity on an ongoing base the Futures owner needs to roll over positions to the next contract.

Futures-trading-chart

Contango and Backwardation (Source: Wikimedia)

Contango and Backwardation are important terms in Futures trading (see chart above). Backwardation, is the market condition wherein the price of a futures contract is trading below the expected spot price (spot price is the price to which the commodity can actually be bought now) at contract maturity.Contango is a situation where the futures price is higher than the spot price. Each Future and each Futures category has a typical pattern of Contango or Backwardation which normally does not change. A contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up (or the time-value-of money, etc.), less income from leasing out the commodity if possible (e.g. gold). For perishable commodities, price differences between near and far delivery are not a contango. If a Future changes its pattern against the spot market (called inverted market) it happens only for a short timeframe and it reverts back in nearly all of the cases. Trader can profit from an inverted market with a high chance of winning. This and other specification of Futures can be used for trading, for example if the price of buying 100 oz. of Gold is 130 000 CHF right now (at March 2017) and the Gold Futures contract price with a delivery date at August 2017 is trading at 135 000 CHF we could buy the Gold now for 130 000 CHF and sell the August 2017 Future now for 135 000 CHF. If we wait till the delivery time in August 2017 we can deliver the Gold for 135 000 CHF (to the owner of the Futures contract) and have a profit of 5 000 CHF. This profit could be predicted at the moment we bought the Spot Gold and sold the Futures. There is even no need for us to make a physical transaction as the Contango or Backwardation of a Future Contract gets close to 0 at the day of delivery (see chart above The term Futures and Commodities are used simultaneously, for further details on Futures categories see (Glossary term Commodities).

Most Futures are traded in Chicago at the CME Exchange which has aquired some other exchanges like Globex. In Europe Eurex is the biggest Futures Exchange.

NFA (National Futures Association) is the US self-regulatory organisation for the US Futures industry. De Facto the NFA sets the standards for most FMOs and the whole Futures industry. The NFA system is comparable with the SRO system in Switzerland. Trading advisors who wish to trade for customers have to register as "Commodity Trading Advisors" with the NFA.

The US Commodity Futures Trading Commission publishes the "Commitment of traders report" (or COT) on a weekly base. These reports provide an overview of who is holding how many futures contracts and how many open interest (means open contracts) are outstanding for which party.

Dr. Mirko C. Ulbrich has years of experience as Futures Trader and Commodity Trading Advisor and deep inside knowledge in Futures and Commodity trading.

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