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Futures - Basic information

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A futures contract is a standardized derivative that is publicly traded on a market exchange. It binds two parties together to exchange an asset at a predetermined future date and price without regard to the current value of an asset at the date of expiry. Futures contracts are often used as investment vehicles, speculation vehicles, or a hedge against risk. They allow exposure to long and short positions while tracking the performance of an underlying asset. Such assets include stocks, commodities, indices, and other types of securities.

 

Key takeaways:

  • Futures contracts oblige a buyer to buy an asset at a predetermined date and price or a seller to sell an asset at a predetermined date and price.
  • Futures contracts have an expiration date.
  • At the date of expiration, the settlement of a futures contract takes place.
  • Futures contracts are derivatives that track an underlying asset.
  • The Commodity Futures Trading Commission (CFTC) oversees the futures market in the United States.

 

The expiration and settlement

The expiration date differentiates between particular futures contracts. For example, a corn futures contract may expire in April and another one in May. On the day of expiry, an asset exchange, also called delivery or settlement, takes place. It can be in cash or physical form. Cash-settled futures contracts are usually used for speculation. Meanwhile, contracts with physical delivery of goods are used to hedge risk, secure materials for production, or serve different purposes. 

 

Open interest

Open interest represents the number of outstanding futures contracts per specific delivery month. Depending on trading activity in the market, this figure may vary between contracts with different maturities and fluctuate from one day to another.

 

Front-month and active-month contracts

The front-month refers to the contract with the nearest maturity date. Commonly, it is considered the most active contract. Nonetheless, as the contract progresses closer to expiration, activity tends to shift to other contracts with later delivery.

 

The illustration displays the daily chart of the September 2024 Nasdaq 100 E-mini Futures (NQU2024). After the expiration, the contract will stop floating on the market.

Source: https://www.tradingview.com/x/l042ZNDX/ 

 

Continuous futures contract

A continuous futures contract is an uninvestable contract created by splicing together multiple futures contracts with different expiration dates. Its purpose is to provide an analyst with a long-term view because actual futures contracts have a limited life span.

 

The image above shows the continuous futures contract for the Nasdaq 100 E-mini Futures (NQ1!). Unlike the regular tradeable futures contract, this contract will float continuously without expiring.

Source: https://www.tradingview.com/x/1EANcLRJ/ 

 

Leverage

Futures contracts are leveraged products that do not require 100% of the contract's value to open a trade. Instead, they require only the initial margin amount, a fraction of the total contract's value. Although, the margin amount and other specific requirements may vary depending on the broker. 

 

Correlation between an underlying asset and derivative

A futures contract is a derivative product that tracks the performance of another investment called an underlying asset. Therefore, the performance between a futures contract and the underlying is correlated. Such correlation can be either positive or negative, depending on the character of a contract.

 

The picture shows the weekly chart of the S&P 500 index (SPX). The orange line represents the S&P 500 E-mini futures contract (ES1!).

Source: https://www.tradingview.com/x/6sHDdUmJ/ 

 

Contango and backwardation

Contango occurs when futures contracts with a nearer maturity date are cheaper than contracts with a later expiration date. Conversely, backwardation refers to a condition when futures contracts with a nearer maturity date are more expensive than those with a later expiration date.

 

Commitment of Traders (CoT)

Commitments of Traders (CoT) shows the open interest in the U.S. futures market among three distinct groups of investors: small speculators, commercial investors, and large speculators. This report is published weekly and is closely watched by commodity and futures traders as it can provide a better understanding of market sentiment.

 

Futures contract types

  • Currency futures
  • Energy futures
  • Financial futures
  • Fiber futures
  • Food futures
  • Grain futures
  • Livestock futures
  • Metal futures

 

Difference between futures and option contracts

Futures contracts are associated with a legal obligation to buy or sell an asset at a predetermined date. Meanwhile, options are associated with an option holder's right to buy or sell an asset; however, this right is executable only if certain conditions are met. Another difference between these asset classes is that futures contracts do not become worthless at expiration. Instead, the settlement or delivery takes place.

 

Futures market regulation

The futures market in the United States is regulated by the Commodity Futures Trading Commission (CFTC), which promotes resilience, integrity, and dynamics of the U.S. derivatives markets.

 

Examples of futures contract exchanges

  • Chicago Mercantile Exchange
  • Chicago Board Options Exchange
  • China Financial Futures Exchange
  • Shanghai Futures Exchange
  • Hong Kong Futures Exchange
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