Futures Market Definition Examples Trading How It Works

Futures Market Definition

Also known as a futures exchange, this auction market facilitates buying, selling, and hedging 24/7 per the rules of its jurisdiction. These exchanges standardize futures contracts involving the trade of underlying assets, i.e., precious metals, agricultural products, and financial securities. The futures market trading serves two primary purposes – speculation (enabling investors to make a profit) and hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more (allowing traders to minimize losses).

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How Does Futures Market Work?

Key Takeaways

A futures market is a financial exchange where traders trade futures contracts for precious metals, agricultural products, stock indices, currency pairs, and interest rates at a pre-determined rate and date.It protects investors and traders from losing money on a transaction even if the price of the commodity or financial instrument increases or decreases later.A futures exchange standardizes futures contracts and allows investors and traders to exchange them on its trading venues or clearinghouses with the help of futures brokers.Futures market investing has two purposes – speculating (allowing investors to profit) and hedging (allowing traders to protect their positions).

Let us say there is a wheat producer who has enough grain to sell on the market. The producer would prefer to sell the grain for a higher price. But the buyer, such as cereal manufacturers, would buy it for a lower price. A central financial exchange, i.e., futures market, facilitates the trade between the two.

Both parties agree to buy and sell the futures market commodity at a specified price at a future date by signing a futures contract. As a result, the market price rise or decline does not affect either the seller or the buyer. In other words, futures contracts protect the producer against market volatility while transferring risk and reward to the investor.

So, if the set price of wheat per unit was $50 on the day of signing the futures contract and the cost is now $100, the buyer will still pay $50 without being affected by the current market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more increase. In this case, the seller may regret it as the selling price for the grain drops to half, even though the current market value of wheat is higher.

Futures Markets Purpose

Futures contracts are exchange-traded derivatives, the value of which depend on the value of the underlying asset. And futures markets allow trading these derivatives later, known as the expiration date, at a pre-determined price. Besides, these exchanges serve other purposes, such as:

Price Discovery or Speculation – Buyers and sellers from all around the world converge on a single marketplace to set commodity and financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more prices for future delivery and profit from market volatility.Price Risk Transfer or Hedging – Buyers and sellers fix commodity and financial instrument prices for future delivery to avoid losses due to market volatility.

Steps In Futures Markets Trading

Futures market trading works similar to that of stock market trading but with a few distinct steps, which are as follows:

Register with a clearinghouse to open a trading account.Making a depositBuying or selling a futures contract at the current market price (the futures price)Purchasing in the future indicates that the buyer is taking a long positionLong PositionLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read moreSelling in the future indicates that the seller is in a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read moreBuying or selling the commodity before it expires, orBuying or selling before the contract’s expiration date to complete the transaction.

Investors typically sell futures contracts before they expire.

Examples

To understand the concept better, here are a few futures market examples shared:

Example #1

Stella is a corn producer who is anticipating a higher price for her harvest. But she worries as she harvests it all at once, putting the corn at risk of spoilageSpoilageSpoilage is defined as waste material released during the normal manufacturing process, where the spoiled material is known as scrap material if it is no longer useful.read more. Her efforts will be for naught if this occurs. On the other hand, there is a company that needs corn in bulk to produce flour. While the firm cannot purchase all of the maize for the year at once, it wants to buy it at a lower price.

They both access a futures market and sign a futures contract to fix the price of corn until the contract expires. It means that regardless of how much the price of grain rises or lowers, the parties will be unaffected. However, if the price of grain rises at the time of sale, Stella will benefit, but the flour-making company will lose. Likewise, if the price decreases, the situation will be vice-versa.

Example #2

Greg invests $100,000 in futures market stocks with a 10% profit margin. As a result, he had to maintain 10% of the stock’s value, or $10,000, with the broker. If stock prices gained 5%, the profit would be $5,000 while keeping merely $10,000 with his broker. As a result, Greg’s profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more on his investment would be 25%. On the other hand, if he had purchased the stocks directly from the stock market, the profit margin would have been 5% only due to the increase in the stock price.

Top Futures Markets

The futures market depends on the futures contract signed between the two parties. It also performs various functions, such as providing physical or electronic trading venues or clearinghouses, standardized contract details, market data, pricing formula, exchange self-regulation, margin mechanisms, price position and limits, settlement processes, delivery times and procedures, and contract size.

Futures exchanges such as the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME), the Chicago Board Options Exchange (CBOE), the Kansas City Board of Trade, the Chicago Board of Trade (CBoT), the Minneapolis Grain Exchange, Intercontinental Exchange, and Eurex let investors trade futures contracts.

The following are some of the highly liquid futures contracts available, along with their denominations:

E-mini S&P 500 (ES) contractsE-mini Dow Jones Industrial Average (YM) futures10 Year Treasury (T)-Notes (ZN)Crude Oil (CL)5 Year T-Notes (ZF)Gold (GC) futuresEuro FX (6E)30 Year T-Notes (ZB)Japanese Yen (6J)2 Year T-Notes (ZT)Eurodollars GE

Another letter and a number follow the symbol for futures contracts. The letter denotes the contract’s expiration month, while the digit beside it represents the year the contract will be valid. The numbers reflect the year’s last one or two digits (for example, 7 for 2017 or 20 for 2020). And the month codes are as follows:

January – FFebruary – GMarch – HApril – JMay – KJune – MJuly – NAugust – QSeptember – UOctober – VNovember – XDecember – Z

For example, if the E-mini S&P 500 contract is set to expire in March 2009, it will be marked as ESH9 or ESH09. Here, H stands for March and 9 or 09 for 2009.