*What are futures contracts, how do they work, why do they exist and how do I trade them*
Welcome back to the blog! In this blog post I am continuing with the “Market Dynamics” series of blog posts and I believe this is now the 3rd instalment. I am using the posts in this series to explain to you, the readers of this blog, the details of certain key elements in financial markets trading and hopefully help you increase your own knowledge of this industry.
If you haven’t read my previous market dynamics blog posts then you can find them below.
What are futures contracts?
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Because a futures contract is a function of an underlying asset, it is considered a derivative product.
They are different to options contracts (previously explained in my Tesla blog post) because options contracts give the buyer the option but NOT an obligation to purchase and receive the underlying asset at a predetermined price prior to the expiration date.
Why do they exist? Who trades them and for what purpose?
The first futures contracts were negotiated for agricultural commodities, and later futures contracts were negotiated for natural resources such as oil. The original use of futures contracts was to mitigate the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions. Being able to lock in a fixed price for the future is beneficial for businesses that operate internationally and are subject to FX exchange rates or for businesses that produce goods that are subject to fluctuations in price.
For example, a farmer grows corn and expects 1 “unit” of corn to be ready for sale in 1 years time. The current market price of 1 unit of corn is $100 and after his costs and intended profit, the farm wants his minimum sale price to be $110 per unit of corn. The farmer wants to eliminate any risks of oversupply in the markets or logistics issues from effecting the price he receives for his corn so he sells (goes short) X number of units in futures contracts with 12 months until expiry for $110 per contract to gain the protection required.
This is a producer hedge trade.
If in 12 months time the price of 1 unit of corn increases to $120 then the farmer will lose $10 per contract ($110 – $120, sell price – buy price). However, he will also be able to sell his actual corn at a market rate of $120 per unit and therefore his net sale price of each unit of corn is $110 which is what he wanted ($120 – $10 loss on the futures contract).
If in 12 months time the price of 1 unit of corn decreases to $100 then the farmer will gain $10 per futures contract ($110 – $100, sell price – buy price). However, he will now only be able to sell his actual corn at a market rate of $100 per unit and therefore his net sale price of each unit of corn is still $110 which is what he wanted ($100 + $10 profit on the futures contract).
It does not matter if the price of corn goes up, down or sideways in the 12 months leading up to the date of expiration. The farmer gets his required price of $110 per unit of corn thanks to the futures contract hedging any price movements.
There is also a consumer or buyers hedge trade using futures contracts.
Now let’s assume you own a BBQ restaurant and corn on the cob is your number 1 side dish. You can use futures contracts to eliminate the risk of price fluctuations effecting your future profits by purchasing futures contracts (going long) for corn to be delivered in 12 months time and locking in the current market price.
Let’s assume you want to pay $110 per unit of corn to be delivered to your restaurant in 12 months time. You purchase futures contracts for $110 with an expiration date in 12 months time. If the price of corn then rises to $150 you will make $40 of profit on the futures contracts but you will also still need to purchase your physical corn at the market price of $150 per unit so your net cost for the corn is $110 per unit. This is as expected and you have successfully hedge an increase in the price of corn.
You will therefore be better off and make more profit on your main business which is the BBQ restaurant compared to other restaurant owners who do not hedge the price of corn.
Then came the speculators…
However, over time investors and traders found that futures contracts could be used for speculating on the potential movements of the price of an asset or security. If a speculator believes the price of an asset, let’s say lean hogs (used for producing that lovely bacon/ribs), is going to increase over the next 6 months because there is going to be a reduction in the number of piglets born in season then he can potentially profit by buying futures contracts.
Let’s assume you buy a lean hog futures contract with 6 month expiry for $50. In 6 months time the price of lean hogs has increased and now cost $75. Before expiration you could sell one lean hog contract at the current market price and this would close out the long position without taking delivery and leave you with a $25 profit. If the price of lean hogs was to fall in that 6 months period then you would lose money.
Alternatively, you could execute the futures contract at expiry and take delivery of your lean hog that is now worth $75 and sell that on the open market at the current price. This would still leave you with a profit of $25 but you have used a different settlement method.
These are two different types of settlement of a futures trade and I will now explain this in more detail because it is important to know the difference. You do not want to be stuck taking delivery of a truck load of lean hogs to your flat in London.
Settlement of futures contracts.
Futures contracts come with specific rules to criteria when they are created. They will have a price, quantity (number of contracts of the asset), expiry date and settlement type.
Cash settlement of futures is made based on the underlying reference rate, such as a short-term interest rate index such as 90 Day T-Bills, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item—for example, it would be impossible to deliver a stock market index.
Physical settlement is when the the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position—that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).
Futures contracts pricing.
Futures contracts are standardized financial contracts that allow holders to buy or sell an underlying asset or commodity at a certain price in the future, which is locked in today. Therefore, the futures contract’s value is based on the commodity’s cash price or spot price.
Futures prices often deviate from the current spot price of the underlying asset because time until expiration is involved which adds an increased risk of changes in value. The price of futures can also be effected by location of delivery upon settles and the product quality.
The shape of futures price curves are important. Depending on the price of futures contracts vs spot price of an asset and the price of far dated futures vs near dated futures contracts decides whether the market is in normal or inverted and whether the market is in Contango or Normal Backwardation. This may sound confusing but I will explain all.
The diagram below shows 2 market conditions for futures prices.
In a normal market (red line), futures contracts are more expensive the further they are away from maturity. If the price of futures contracts for an asset are cheaper the further they are away from maturity, the market is considered inverted.
A futures price curve might become inverted because of fundamental factors influencing the supply and demand of contracts on the market. The cost to carry a physical asset or to finance a financial asset and the storage/transport costs of a physical asset/commodity will all have an effect on the futures price curve.
Spot price = current market price if there asset or security was delivered today.
Normal and inverted markets are used to define the shape of the price curve of futures contracts that expire at different maturities. However, there are two other types of futures pricing that you will also need to understand depending on where futures contracts are in relation to spot price.
Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies futures prices are falling over time as new information brings them into line with the expected future spot price.
Normal Backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are net long in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.
As a futures contract gets closer to maturity it should converge on the spot price. This is because on the maturity date when the contract is delivered the futures price and spot price should be equal. If it isn’t then there is a clear and easy way to make money with a simple arbitrage trade. If the future price is above spot price at maturity then you could simply buy, let’s say crude oil on the spot price and sell it immediately on the futures for a profit with zero risk. This is very rare and unlikely.
The Crude Oil futures price crisis.
A very good example of why it is important that all traders and investors understand what futures contracts are and how they differ from normal assets and other financial instruments is the crude oil crisis that occurred in April this year.
On the 20th of April this year, the price of 1st to expire crude oil futures contracts went below $0 for the first time in history. The price chart is below.
This made headline news and was crazy to see but actually it was created entirely by a complete reduction of short term demand and increasing supply of crude oil. Because the April contract was set to expire the very next day and there was no demand for crude oil, the price fell through the floor. No one wanted to take immediate delivery of crude.
However, the next months futures (May 2020) were still trading above zero and the contracts with even greater time until maturity were still trading above $30. Crude oil is a weird commodity because it tends to have a “humped” futures price curve where it is normal in the short term but inverted for the longer term maturity contracts. Crude oil can and has switched from Backwardation to Contango depending on supply levels.
If you haven’t read my previous blog post explaining the 2020 crude oil crisis in my own words then click here to read it now. It’s good.
Crude Oil futures have been in Contango for quite some time as you can see on the chart above. However towards the end of Q1 this year the spread between contracts began to expand as over supply of oil in to the markets began to increase and logistics of transport and storage became a real issue. On April 20th when the 1st to expire contracts went negative, the spread was at its widest because traders simply did not want to take delivery of crude oil. This large price spread was called SUPER CONTANGO.
I was also a featured guest in an article written by Vanity Fair magazine discussing the day that Crude Oil futures went below $0 for the first time in history. You can read that article by clicking on the link below.
How do I trade futures contracts?
My main use for futures contracts is when I trade Volatility through high impact news events by trading VIX futures. I use the 1st to expire contracts on VIX to take a position on market volatility and ultimate speculate on whether the underlying asset (the volatility index) is going to go up or down.
The chart below shows a short duration VIX futures day trade I entered on Friday last week.
I shorted or sold VIX futures that had an expiry date on the 16th September 2020 so approximately 6 weeks from the current date of the trade. By selling VIX futures I will directly speculating that the underlying asset (the volatility index) was going to decrease in value, which it did.
The reason I sold the September 2020 futures contract and not the August contract was because the spread was 50% cheaper which was a no brainer for me. It made the trade cheaper to enter and actually more profitable because I got reduced spreads on the way in to the position and on the way out (when I closed it).
The reason I sold VIX futures was to benefit from the immediate decrease in stock market volatile after the announcement that U.S. employment had once again increased month on month. This was a relatively good thing for the economy and therefore investors and speculators confidence in the markets increased.
The chart below shows the both the September 2020 and August 2020 VIX futures prices and also a short term ETF price that we will use as a substitute for spot price.
Firstly, the VIX does not have a spot price, instead investors must trade the index itself. However, the Chicago Board Options Exchange has created the futures and options contracts for it based on the VIX. Instead of spot price I have used a short term futures ETF which is as close to the underlying VIX as i can get without trading the index itself.
As you can see, the “spot” price is the lowest with the first to expire futures contracts trading slightly higher and then the September 2020 futures contracts price is the most expensive. This is a perfect example of a normal market futures price curve in Contango.
Hopefully this blog post has helped you understand a little bit more about the futures trading markets and how I trade them. Trading futures contracts actually forms a very small part of my overall trading volume but I believe it is still very important to understand how futures pricing works and what they are designed for. They certainly have their uses in the global economy.
For those of you who want to look at futures trading strategies in more detail then I recommend reading a book by Jack Schwager (author of market wizards) called A Complete Guide to the Futures Market. You can find it on amazon by clicking on the image below.
If you are interested in learning my personal trading strategies, please consider my Mastering The Markets – Retail Trading Course. Head over to my Trading Education page to check out all of my education packages and the deals available.
All my technical analysis is done using the TradingView platform. You can get access via the link below.
My preferred broker of choice is IC Markets. Low spreads and trading costs really help long term profitability. A link to their site is below.
FTMO Trader Funding Programme.
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DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.