What is a future?
A future is a type of derivative contract that represents an agreement to buy or sell an asset at a specified future date, for a price determined today. It is a standardized contract traded on a derivatives exchange. Futures are an important hedging/insurance tool that can be used to protect against adverse price movements, or to fix the price of otherwise volatile assets to assist in corporate long-term budgeting. They may also be used to express an opinion about the direction of the market. Futures were initially created as a hedging product for commodity producers, but today exist on a wide range of underlying assets besides commodities such as currencies, interest rates, indices and stocks.
The standardized features of a future contract include the contract size, expiration date and delivery arrangement. The contract size is the standardized quantity of the underlying asset that the future controls. For example, an oil future represents a contract on 1000 barrels of oil. Futures trade in specific expiration cycles that can be weekly, monthly, quarterly, etc. The expiration date is the date on which the contract lapses. The delivery arrangement details whether the future will be settled physically or in cash. A commodity producer looking to lock in a price for their product would likely prefer a physically settled commodity future, whereas an investor looking to express a view on the commodity’s price movement with no intention of holding the asset would prefer a cash settlement.
What do futures mean for the markets
Futures, like other derivatives, are used to hedge, which is to eliminate or reduce the risk of adverse price movements. A wheat farmer can use a physically settled future to lock in the sale of the harvest at a known price, and so eliminate uncertainty on the proceeds of the future sale.
Futures can also be used to take a position and express an opinion on the future direction of the market, giving investors access to products that would otherwise not be accessible. For example, it is more efficient for an investor to buy a Eurostoxx 50 future than to buy every underlying stock in the index. At the same time, as opposed to holding a couple of single securities, futures give an investor exposure to a wider market as well as the ability to express a macro view. The leverage effect in future contracts can give an investor a large exposure for a small initial amount of capital, which magnifies both profits and losses. Due to the leveraged nature and the relatively large size of most contracts, futures are more commonly traded by institutional investors than retail investors.
- Imagine an investor that buys a Eurostoxx 50 future in March that expires in December, has a multiplier of 10 and is priced at 3100. Suppose that in December the future expires at a level of 3150; this means the investor’s profit amounts to €50 x 10 = €500. If the future expires at a level of 3050 instead, the investor loses €500.