What are futures?

A future is a derivative financial instrument where two parties agree to buy or sell an asset at a predetermined price (the forward price) on a specific date in the future. These contracts are standardized and traded on exchanges, making them accessible to speculators and businesses alike.

Example: Hedging with Futures

Imagine you’re a baker selling bagels for $6 a dozen, using flour that costs $4 per batch. This gives you a $2 gross profit margin per dozen. If flour prices suddenly rise to $6, your profit disappears. To protect against such fluctuations, you could lock in a future price for flour by entering a futures contract with a supplier. This ensures price stability and allows you to focus on running your bakery.

Key Components of Futures

  • 1. Forward Price: The agreed-upon price for the asset in the future
  • 2. Delivery Date: The date when the contract is settled
  • 3. Long and Short Positions:
    • The long position commits to buying the asset at the forward price
    • The short position commits to selling the asset at the forward price
While futures were originally created for businesses to hedge costs, they are now widely used by speculators seeking to profit from price changes in commodities, financial assets, and even cryptocurrencies like Bitcoin.

How Do Futures Work for Speculation?

Speculators use futures to bet on the direction of an asset's price. Consider the case of gold:
• Going Long
You expect gold prices to rise. Suppose the current spot price of gold is $1,500 per ounce, but the forward price for a one-year contract is $1,550. If the spot price rises to $1,700 when the contract expires, you earn $15,000 on a 100-ounce contract because you buy at the forward price of $1,550 and sell at the spot price of $1,700.
• Going Short
You expect gold prices to fall. By shorting the contract at $1,550, you profit if the spot price drops below $1,550, as you can buy gold at the lower spot price and sell it at the higher forward price.

Cash Settlement and Leverage

Physical vs. Cash Settlement
While some futures contracts involve physical delivery of the underlying asset, many settle in cash. This eliminates logistical challenges like transporting or storing commodities.
Leverage in Futures
Futures require only a fraction of the contract value to be deposited upfront as margin. For example, a $155,000 gold contract might only require a $7,750 margin deposit. While this leverage amplifies potential gains, it also magnifies losses. A significant drop in gold prices could result in losses far exceeding the initial deposit.

Applications and Risks of Futures

Hedging and Portfolio Management
Futures allow investors to manage risk and alter the risk-return characteristics of their portfolios. For example, they can:
• Hedge against price volatility in commodities or financial assets
• Lock in returns from specific investments
Forward Prices as Market Indicators
Forward prices reflect market expectations and offer insights into price trends. For instance:
Futures Curves: Graphs showing forward prices for various contract dates can reveal patterns. An upward slope in gold's future curve might indicate expected price appreciation, while seasonal patterns in natural gas prices reflect higher demand during winter.

Are Futures Right for You?

While futures provide a powerful tool for exposure to various assets, they come with risks—particularly due to leverage. They are best suited for experienced investors or businesses with specific hedging needs. Understanding their complexities is crucial before diving into the futures market.

Conclusion

Futures contracts, though rooted in practicality for businesses, have evolved into versatile instruments for hedging, speculation, and risk management. They offer valuable insights into market expectations and the opportunity to profit from price changes. However, their leverage and complexity make them unsuitable for the inexperienced investor.