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Stock market instruments: what are futures and how they work

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Stock market instruments: what are futures and how they work

Previously on our blog already was brought up by the topic of derivative financial instruments (derivatives) and described some of their classes.Buying or selling such exchange instruments is very often discussed as “selling the air” and obviously harmful speculation. In fact, the importance of the same options and futures for the stock market and, more broadly, for the country’s economy can hardly be overestimated. Today we will talk about futures contracts and the logic of working with them.

History of futures

The first futures exchange appeared in Osaka, the ancient capital of Japan, back in the Middle Ages, where the future harvest of rice was traded. However, modern futures trading originated in Chicago in the mid-nineteenth century. In the 1840s, Chicago became the commercial center of the Midwest. It was promoted by its convenient geographical position and well-developed infrastructure (railroad and telegraph). It was around this time that the inventor of the Cyrus McCormick. after completing his father’s project, introduced a grain thresher that increased farm productivity.
Stock market instruments: what are futures and how they work
Farmers from the Midwest came to Chicago to sell their grain to dealers, and there were no well-established procedures for evaluating the goods or determining their exact weight. Very often this was left to the dealer’s discretion. In addition, farmers who brought goods (grain or livestock) might find that there were already too many of their kind in Chicago, and supply far exceeded demand, affecting the price of the goods. Buyers, in turn, faced the problem of transporting grain, especially in the wintertime.
Because of these difficult conditions, farmers and merchants began to make contracts with delayed delivery of goods. The scheme might have been as follows: the farmer sold grain to the merchant in late fall or early winter, which the merchant had to store until it could be transported, for example, by river. But the risk of a fall in price over the winter has not been eliminated. To protect themselves against this, traders who bought grain would go to Chicago and make contracts with processors there to deliver the grain in the spring. This way they guaranteed themselves both buyers and a reasonable price for the grain.
In 1848, the first of Chicago’s commodity exchanges was created, which was called the Board of Trade of the City of Chicago (CBOT). On March 13, 1851 the first futures contract was struck there for 3, 000 bushels (about 75 tons) of corn to be delivered in June at one bushel less than one cent the day before.
Stock market instruments: what are futures and how they work
Futures contracts gradually became widespread because of the benefits associated with their use. A purchaser of a futures contract could change his mind about buying grain and resell the right to an interested party. Or a farmer who, for whatever reason, could not or would not deliver the agreed amount of grain at the agreed time, could sell this obligation (for which he was entitled to money) to another farmer. In the event of bad weather, the buyers of the futures contracts benefited greatly, because they had the right to buy grain at a much lower price than it was worth after a bad harvest. However, if, on the contrary, there was overproduction and the price fell, the futures contract might not be as profitable.
Quite quickly, speculators, who did not really need any grain, also became interested in futures. Such players pursued only one goal: to buy cheaper and sell dearer.
Initially, only grains (corn, wheat, oats, etc.) were traded on the exchange, but later futures on assets outside this area were introduced – in 1960 the Chicago Mercantile Exchange (CME), a competitor to CBOT, began trading futures on live cattle and frozen pork. In 1982, the CBOT introduced fully electronic gold and silver futures contracts. Then in 1982, the futures on the most famous U.S. stock index, the SP 500, appeared. In 1999, the CME introduced weather futures for the first time. Despite the somewhat unusual nature of this instrument, they are very important to the U.S. economy by reducing price risks in the country’s agriculture and energy sectors.

What is modern futures

As we found out above, futures are an obligation to buy or sell a certain asset (called an underlying) at a certain price at a certain date in the future. Each futures contract is characterized by the quantity of the underlying asset (for example, pieces of stock), the date when the contract is executed (expiration date), and, actually, the price (strike price) at which the buyer agrees to buy the underlying asset, and the owner agrees to sell.
Thus, the seller undertakes to sell a certain quantity of the underlying asset at a certain price in the future, and the buyer undertakes to buy it at the agreed price. The transaction is guaranteed by the exchange, which takes security deposits from both parties to the transaction.
The underlying assets can be :

  • A certain number of shares (stock futures);
  • Stock indices (index futures);
  • Currency (currency futures);
  • Commodities traded on exchanges, such as oil (commodity futures).
  • Interest rates (interest rate futures).

All futures contracts are traded on special trading floors – futures sections of stock commodity or currency exchanges. In Russia, for example, the Moscow Exchange has a futures market, where futures and options are traded.
Stock market instruments: what are futures and how they work
RTS-3.14 futures index chart from the terminal SMARTx
Before any futures contract is put into circulation, the exchange determines the terms of its trading, which is called the “specification”. This document contains information on the underlying asset, the number of units of that asset, the expiration (execution) date of the futures, the value of the minimum price step, etc. An example of such a specification is the description of futures on RTS Index
There are two types of futures: settlement and delivery futures. In the case of the latter, physical delivery of the underlying asset, such as oil or currency, is allowed. Sometimes such delivery is not implied and the futures are settled. In this case at the moment of its expiration the parties of the transaction receive the difference between the contract price and the settlement price on the expiration date, multiplied by the number of the contracts available. Futures on indexes refer just to the settlement ones, because it is impossible to deliver them.
When trading futures contracts, the value of the position is recalculated daily in relation to the previous day with a debit/credit to the investor’s account. That is, the difference between the purchase or sale price of the futures and its estimated expiration price is credited to the trader’s account daily – this is the concept of variation margin.
Futures have an expiration date, which is coded in their name. For example, in case of RTS index, the name is formed as follows: RTS – <month of execution> .<year of execution> (for example, RTS-6.14 futures will be executed in June 2014).

How it works

As it is clear from the history of futures contracts, one of their main purposes is to insure against financial risks (so-called hedging) – this tool is used by real suppliers or consumers of the commodity, which is the underlying asset. Experienced traders and investors use futures (often settled) to speculate and make profits.
Stock market instruments: what are futures and how they work
Futures are a fairly liquid instrument, which, however, is unstable and, accordingly, carries a lot of risk for the investor.
When a futures contract that one trader has sold to another is due, several outcomes are generally possible. The financial balance of the parties may not change, or one of the traders may make a profit.
If the security price went up, the buyer wins, but if the price goes down, the seller celebrates success and is most likely to have got exactly what he expected. If the security’s price does not change, the sums in the accounts of the transaction participants should not change either.
Unlike the option, the futures are not a right, but an obligation for the seller to sell a certain quantity of an underlying asset at a certain price in the future, and for the buyer to buy it. The execution of the transaction is guaranteed by the exchange, which charges both parties with security deposits (margin) – that is, you do not have to pay the entire futures price immediately, but only the security is frozen in the account. This procedure is done with the buyer’s account and the seller’s account in the transaction.
The value of the guarantee collateral (SC) for each contract is considered by the exchange. If at any moment the funds on the investor’s account become less than the minimum allowable level of CS, the broker sends him a request to replenish the balance, but if it does not happen, part of the positions will be closed by force (margin call). In order to avoid such situation the trader should keep the amount of money on the account, rather significantly exceeding the amount of the collateral – because if the futures price changes significantly, his funds may not be enough to cover the position. The collateral is frozen in the trader’s account until the trade is paid off.
At the time of writing, the current value of the security charged to clients wishing to trade in RTS Index futures is 11, 064.14 (more here ). Accordingly, if the trader has 50, 000 rubles in his account. That is, the trader will be able to buy only 4 such contracts. At the same time, an amount of 44, 256.56 rubles will be reserved. This means that the trader will have only 5, 743.44 rubles available on his account. And if the market goes against a certain number of points, the expected loss will exceed the available funds, and a margin call will occur.
Stock market instruments: what are futures and how they work
As you can see, much depends on the futures price, which may change under the influence of various factors. That is why this exchange instrument belongs to the category of risky ones.

Why speculation and futures are needed

Very often people who are not very familiar with the specifics of the stock market confuse it with Forex (although it is not especially justly ) and branded as some kind of “swindle, ” where speculators rob gullible newcomers to nothing. In fact, it’s not like that, and stock speculation plays an important role in the economy. Speculators buy cheap and sell dear, but beyond the pursuit of riches, they influence price. When the price of a stock or other exchange-traded instrument is undervalued, a successful speculator buys – which drives the price up. Similarly, if an asset is overvalued, an experienced player may short sell (selling securities “borrowed” from a broker) – such actions, on the contrary, contribute to a decrease in the price.
Stock market instruments: what are futures and how they work
When there are many stock market professionals who look at the stock market from different angles and use a lot of data about both the situation in the country and about a particular company for analysis, their decisions have an impact on the market as a whole.
Similarly, to imagine the role of futures, it is worth imagining what would happen in the absence of this financial instrument as such. Let us imagine that a company producing oil is trying to forecast the necessary production volumes. Like any business, the company wants to make maximum profit with minimum risk. In this situation, you can’t just produce as much oil as possible and sell it all out. It is necessary to analyze not only the current price, but also what level it might be at in the future.
That said, those who produce, transport, and store oil are not necessarily analysts and have access to the most comprehensive forecasts of the possible price of oil. Therefore, a producer cannot know exactly how much a barrel of oil will be worth a year from now-$50, $60, or $120-and produce the appropriate amount of it. To get a guaranteed satisfactory price, the company simply sells futures to minimize the risk.
On the other hand, the stock speculator in the example above, may consider that the price of a particular futures is over- or undervalued, and take appropriate action, equalizing it to a fair
At first glance, the importance of establishing a fair price in the market does not seem to be such a necessary thing, but in fact it is extremely important for the equitable use of society’s resources. It is at the stock exchange that capital is redistributed between countries, sectors of the economy and businesses on the one hand, and various groups of investors on the other. Without the stock market and the instruments by means of which it functions (including derivatives), the effective development of the economy and satisfaction of the needs of each individual member of society are impossible.

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