Key Takeaways

  • A futures contract is a contractual obligation to buy or sell an asset.
  • The deal's price is locked in, and the asset will be delivered ranged future date.
  • These financial contracts apply to various commodities (oil, gold, wheat, silver) and financial products (interest rates, currencies, stock indices).
  • Futures trading offers leverage, liquidity, and a means for price discovery and risk management.
  • Popular choices for futures include agricultural products, natural resources, forex trading, and interest rates.
  • Futures trading has challenges, including reliance on leverage, expiration dates, and the risk of not receiving the goods.
  • Weigh the pros and cons of trading futures to facilitate risk management and optimize benefits.

Futures contracts are legal contracts pertaining to predicted future values of currencies, commodities, and stock market indexes. In the case of commodities futures, this involves a commitment to deliver or receive an amount of a commodity at a specific price on a specific future date. 

Commodity futures contracts serve essential functions in financial markets, including leverage – borrowing to increase buying power – which can maximize gains and losses and increase market volatility. 

They also allow traders to hold a large amount of an asset for comparatively low capital. This can be an advantage, but it can also increase risk.

These are only a few of the advantages and disadvantages of futures contracts. This article will cover several more and provide other fundamental information. 

Defining Futures Contracts: How Do Futures Contracts Work?

At the most basic level, futures contracts are financial agreements that obligate the buyer to buy, or the seller to sell, an underlying asset by a specified date for a pre-agreed-on price. 

This price is irrespective of prevailing market prices for the commodity or asset at the time of final settlement. 

Typically, futures contracts are relatively short, spanning only weeks to months, and traded through futures exchanges. They are written for a uniform set of features.

Investors trade futures contracts on futures exchanges. They can trade many commodities as futures contracts. 

This includes tangible goods such as: 

  • Oil
  • Gold
  • Wheat
  • Silver

They can also be financial products, including: 

  • External interest rates
  • Currencies
  • Stock market indices
  • Complex interest-rate derivatives in the derivatives market

These contracts are the vehicle of choice for investors hedging against price volatility and speculation in futures on price fluctuations. 

Differences Between Futures Contracts and Other Financial Instruments

Many people conflate futures contracts with other financial instruments, but there are significant differences to note between each. 

Forward Contracts

Like futures, forward contracts are agreements to buy or sell an asset at a future date. 

However, unlike standardized futures contracts sold in exchange-trading environments, most forward contracts are nonstandardized, privately negotiated agreements between two parties.

Options

Options grant the holder the right (but not the obligation) to buy/sell an asset at a specified price on/before a set date at the same time. 

Conversely, futures contracts make it obligatory for the buyer and seller to transact at the specified price and date.

Stocks and Bonds

Stocks represent ownership in a company. Bonds are debt instruments companies, governments, and other entities use to raise money. 

Futures contracts are not claims to ownership or debt but entitlements to buy or sell something at a future date for a current price.

Swaps

Swaps are derivative contracts in which two counterparties agree to exchange cash flows or other financial instruments. 

In contrast to futures contracts, swaps are typically tailored bilateral agreements traded over the counter and are not standardized.

Popular Futures Choices

Hedging with futures is a common practice, and certain futures are more popular than others.

Common applications include:

  • Crops like wheat, corn, and soybeans
  • Agricultural products, including orange juice and oranges
  • The natural resource segment, including oil, gas, and coal
  • Forex or foreign currency trading
  • Interest rates 

Pricing Futures Contracts

One of the primary determinants in the pricing of contracts for futures trading is the cost-of-carry model. This model considers the net cost of holding or “carrying” an underlying asset until the date it is delivered.

These costs (incurred by the seller) are taken into account when pricing a futures contract. They include the cost of storing it and insurance.

Factors Influencing Futures Pricing

Other factors that influence futures pricing include:

  1. Storage Costs: For commodities that require physical storage, the cost of storing the asset until the contract's expiration affects the futures price. Higher storage costs typically increase the futures price.
  2. Interest Rates: The risk-free interest rate represents the opportunity cost of capital. Higher interest rates increase the futures price because holding the asset ties up capital that could otherwise earn interest.
  3. Convenience Yield: The convenience yield is the non-monetary benefit of holding the physical asset rather than the futures contract. For example, holding physical oil might benefit an oil refiner. A higher convenience yield typically lowers the futures price.

Comparison with Other Pricing Models

While the cost-of-carry model is primarily used for futures contracts, other pricing models, like the Black-Scholes model, are used for options. 

The Black-Scholes Model

The Black-Scholes model calculates the fair value of options using factors such as: 

  • The underlying asset's price
  • Strike price
  • Volatility
  • Time to expiration
  • Risk-free interest rate

Unlike futures contracts, options give the holder the right, but not the obligation, to buy or sell the underlying asset, which introduces different pricing dynamics.

Despite its widespread use, the Black-Scholes model has limitations because it relies on several assumptions that may not occur. 

For instance, it assumes constant volatility and interest rates and doesn't account for the possibility of early exercise in American options. As a result, the model's outcomes can sometimes be unreliable.

The Binomial Model

Another widely used approach to pricing options is the Binomial model. It uses a discrete-time framework to evaluate options by considering multiple paths the underlying asset's price might take.

The Binomial model creates a risk-free portfolio by combining options and the underlying asset. This technique allows for the options’ fair valuation based on arbitrage-free pricing.

Payoff Profiles for Futures Contracts

Long and short futures have different payoff profiles regarding futures contracts.

Long Futures

A long futures position involves buying a futures contract with the expectation the price of the underlying asset will increase. 

With PT as the asset’s price at the end of the financial contract and K as the strike price, the formula for a long futures payoff structure is:

  • payoff = PT – K

Example: Suppose an investor buys a crude oil futures contract at $50 per barrel. At expiration, if the price of crude oil rises to $60 per barrel, the payoff would be:

Payoff = $60− $50 = $10 per barrel

Conversely, if the price of crude oil falls to $40 per barrel, the payoff would be:

Payoff = $40 − $50 = −$10 per barrel

In this case, the investor benefits from the increase in the price of crude oil because the payoff is positive when the price at expiration is higher than the strike price. 

If the price decreases, the payoff is negative. This makes it a loss for the person investing in futures.

Short Futures

A short futures position involves selling a futures contract, expecting the underlying asset's price to decrease so the trader profits from market downtrends. 

The payoff structure for a short futures position is:

  • payoff = K – PT

Example: Suppose an investor sells a gold futures contract at $1,800 per ounce. If the price of gold falls to $1,700 per ounce when it expires, the payoff would be:

Payoff = $1,800 − $1,700 = $100 per ounce

Now, if the price of gold rises to $1,900 per ounce, the payoff would be:

Payoff = $1,800 − $1,900 = −$100 per ounce

In this example, the investor benefits from the decrease in the price of gold, as the payoff is positive when the price at expiration is lower than its price at the strike. If the price increases, the payoff is negative, demonstrating a loss for the investor.

The Advantages of Futures Contracts

Here are seven advantages of futures contracts that appeal to hedgers and speculators alike.

  1. Opens the Markets to Investors

Futures contracts can be helpful to risk-tolerant investors. They allow investors to participate in markets they would otherwise not have access to.

  1. Stable Margin Requirements

Margin requirements for most commodities and currencies are well-established in the futures market. Thus, traders know how much margin they should put up in a contract.

  1. No Time Decay 

In options, the value of assets declines over time, severely reducing the trader's profitability. This is known as time decay. A futures trader does not have to worry about time decay.

  1. High Liquidity

Most futures markets offer high liquidity, especially for currencies, indexes, and commonly traded commodities. This allows traders to enter and exit the market at their convenience.

  1. Simple Pricing

Unlike the complicated Black-Scholes Model-based options pricing, futures pricing is relatively easy to understand. It's usually based on the cost-of-carry model, under which the futures price is determined by adding the cost of carrying to the asset's spot price.

  1. Protection Against Price Fluctuations

Forward contracts are a hedging tool in industries with high price fluctuations. Farmers, for example, use these contracts to protect themselves against the risk of a drop in crop prices.

  1. Hedging Against Future Risks

Many people enter into forward contracts for better risk management. Companies often use these contracts to limit risk from foreign currency exchange.

Real-Life Examples of Futures Contracts

To demonstrate how these contracts are used, here are two futures contracts examples:

Corporate Risk Management

A U.S.-based company incurs labor and manufacturing costs in dollars but exports its final products to the European market and receives payment in Euros. 

The company supplies goods at a lead time of six months, which exposes it to the risk of exchange rate fluctuations. 

To avoid this risk, the company can use a forward contract to sell its goods at today's exchange rate, even though the delivery will be made after six months.

Agricultural Hedging

A farmer plants wheat and expects to harvest 8,000 bushels when the crop is ready. 

Unsure of the prices at the time of harvest, she can sell the entire crop at a fixed price well before the actual harvest, with delivery to be made at a future date. In this case, that is five months from the date of the agricultural contract agreement.

Although the farmer does not get the sale proceeds at the time of the agreement, the transaction protects against fluctuations in currency exchange rates and price drops in the wheat market.

The Disadvantages of Futures Contracts

Certain disadvantages make futures contracts a less appealing option.

Here are four of them:

  1. No Control Over Future Events

One common drawback of futures trading is that you don't have any control over future events. Natural disasters, unexpected weather conditions, political issues, and other factors can completely disrupt the estimated demand-supply equilibrium.

  1. Leverage Issues

High leverage can result in rapid fluctuations in futures prices. The prices can go up and down daily or even within minutes.

  1. Expiration Dates

Futures contracts have an expiration date. As the expiration date approaches, the contracted prices for the given assets can become less attractive, making a futures contract sometimes a worthless investment.

  1. Physical Delivery Risk

Some futures contracts require physical delivery of the underlying asset when it expires. This can pose logistical challenges and costs for traders who do not intend to take possession of the physical commodity. 

Then, they need to consider storage, transportation, and insurance for physical delivery, all of which can be cumbersome and expensive. This is particularly challenging for commodities like oil, agricultural products, or metals.

Bottom Line: Balancing the Pros and Cons of Futures Trading

The pros and cons of futures trading must be considered to manage risk and optimize benefits. Use this guide as a starting point for your research to make the most informed choices.

If you need help with the advantages and disadvantages of futures contracts, post your legal need on UpCounsel's marketplace. 

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