Futures Markets and Contracts

Futures contracts are similar to <a title="Introduction to Forward Contracts" href="https://financetrain.com/introduction-to-forward-contracts/">forward contracts</a>, where two parties agree to buy or sell an underlying asset at a predetermined price on a pre-specified date.

The key difference between the two is that unlike a forward contract, which is traded over-the-counter, a futures contract is traded on an organized exchange.

Just like a forward contract, a futures contract can also be deliverable or cash settled. Because a futures contract is traded on an exchange, it gives rise to a few more differences between futures and forwards.

The following is a list of key differences:
<ol>
	<li>Futures contracts are traded on an exchange while forward contracts are privately traded.</li>
	<li>Since they are traded on exchange, futures contracts are highly standardized. Forward contracts, on the other hand, are customized as per the requirements of the counterparties.</li>
	<li>A single clearinghouse acts as the counterparty for all futures contracts. This means that the clearinghouse is the buyer for every seller and seller for every buyer. This eliminates the risk of default, and also allows traders to reverse their positions at a future date.</li>
	<li>Futures contracts require a margin to be posted at the contract initiation, which fluctuates as the futures prices fluctuate. There is no such margin requirement in a forward contract.</li>
	<li>The government regulates futures market while the forward market is not regulated.</li>
</ol>
In a futures contract, the buyer of the contract is said to have a long position and the seller is said to have a short position. The long is required to buy the underlying asset as per the specified time and price and the short is required to deliver this underlying asset.

In terms of standardization, the futures markets have specifications for various things such as the quality of the underlying asset, quantity, delivery dates, price movements, etc. For example, 100 shares of a company may form one futures contract.

Futures contracts are used by both speculators to gain market exposure, and hedgers to mitigate their risks or reduce their exposure to price changes.

Characteristics of Futures Contracts

In order to enter into a <a title="Characteristics of Futures Contracts" href="https://financetrain.com/characteristics-of-futures-contracts/">futures contract</a>, the trader needs to deposit a margin with its broker, which in turn deposits this margin with the clearinghouse.

Since the clearinghouse is the counterparty in every futures contract, the margin money is required as a guarantee to protect the clearinghouse from defaults by traders.

The margin needs to be deposited for both long and short positions.

The traders are also required to settle their accounts on a daily basis, and as the futures prices change, the margin requirement also changes. There are three types of margin that one needs to understand.

Initial margin: This is the initial margin that the trader needs to deposit in order to enter into a trade. This is usually low (3-5%).

Maintenance margin: As the prices fluctuate, the margin requirements also change. The maintenance margin is the minimum amount of margin that must be maintained in the futures margin account. If the margin balance falls below this maintenance margin, the trader will receive a margin call to deposit more funds in order to bring the margin balance back to the initial margin level. For example, the initial margin could be $5,000 and maintenance margin could be $4,000 on a trade of $100,000. If the margin balance goes below $4,000 the trader will receive a margin call.

Variation margin: This refers to the amount of additional funds that need to be deposited in order to bring the margin balance back to the initial margin level. For example, if the maintenance margin is $5000 and the current margin is $3000, then the trader will receive a margin call. The variation margin will be $2000.

Both the initial and the maintenance margin requirements are set by the clearinghouse. They are calculated based on the historical daily price volatility of the underlying assets.

For the purpose of calculating the margin requirement, the settlement price is used. The settlement price is calculated as the average price during the last closing period. They do not use the closing price as the settlement price to avoid any price manipulation by the traders.

Role of Margin Money in Futures Trading

Futures exchanges impose a price limit on how much the futures price can change from the previous day’s settlement price. If traders want to trade at a price above or below this price limit, the trade will not take place.  Till the time the price is outside the limit and no trade can take place, the price is locked limit, and the traders are locked in their positions.

Assume that the previous day’s settlement price of a futures contract was $3.06, and the daily price limit on the contract is 4 cents. In this can the contract can only trade between $3.01 and $3.11.

If the traders want to trade at $3.12, the trade will not take place. Instead the price will be reported at $3.11. Since the price has changed upto the maximum limit, it is said to have made a limit move and the price is said to be limit up. Similarly, if today’s settlement price was $3.01 it is said to be limit down.

Price Limits in Futures Contracts

In a futures contract, the margin balance is adjusted everyday based on the changes in the settlement price from the previous day. This process is called mark-to-market.

Usually, marking to market (MTM) is does on a daily basis, however exchanges may require more frequent marking to market under extreme market conditions.

In this article, we will take an example to understand margin calculations work.

Assume a long position in 10 futures contracts on XYZ stock. Each contract covers 100 stocks.

The contract price is $10, the initial margin required is $100 and the maintenance margin required is $75.

For 10 contracts, the total initial margin is $1,000 and maintenance margin is $750.

During the next three days, the price changes as follows:

Day 1: -30 cents

Day 2: +10 cent

Day 3: -30 cents

Let's compute the margin balance for each of the five days.

Since there are 100 stocks in each futures contract, a 1 cent change in price changes the contract value by $1 or $10 for 10 contracts.

The following table shows the margin balance for the three days.
<table width="427" class="mytable">
<tbody>
<tr>
<th scope="colspan">Day</th>
<th scope="colspan">Required Deposit</th>
<th scope="colspan">Price/Stock</th>
<th scope="colspan">Daily Change</th>
<th scope="colspan">Gain/Loss</th>
<th scope="colspan">Balance</th>
</tr>
<tr>
<td valign="top" nowrap="nowrap" width="65">
0
</td>
<td valign="top" nowrap="nowrap" width="102">
1000
</td>
<td valign="top" nowrap="nowrap" width="65">
10
</td>
<td valign="top" nowrap="nowrap" width="65">
0
</td>
<td valign="top" nowrap="nowrap" width="65">
0
</td>
<td valign="top" nowrap="nowrap" width="65">
1000
</td>
</tr>
<tr>
<td valign="top" nowrap="nowrap" width="65">
1
</td>
<td valign="top" nowrap="nowrap" width="102">0</td>
<td valign="top" nowrap="nowrap" width="65">
9.7
</td>
<td valign="top" nowrap="nowrap" width="65">
-0.3
</td>
<td valign="top" nowrap="nowrap" width="65">
-300
</td>
<td valign="top" nowrap="nowrap" width="65">
700
</td>
</tr>
<tr>
<td valign="top" nowrap="nowrap" width="65">
2
</td>
<td valign="top" nowrap="nowrap" width="102">
300
</td>
<td valign="top" nowrap="nowrap" width="65">
9.8
</td>
<td valign="top" nowrap="nowrap" width="65">
0.1
</td>
<td valign="top" nowrap="nowrap" width="65">
100
</td>
<td valign="top" nowrap="nowrap" width="65">
1100
</td>
</tr>
<tr>
<td valign="top" nowrap="nowrap" width="65">
3
</td>
<td valign="top" nowrap="nowrap" width="102">
0
</td>
<td valign="top" nowrap="nowrap" width="65">
9.5
</td>
<td valign="top" nowrap="nowrap" width="65">
-0.3
</td>
<td valign="top" nowrap="nowrap" width="65">
-300
</td>
<td valign="top" nowrap="nowrap" width="65">
800
</td>
</tr>
</tbody>
</table>
Let’s understand the margin calculation on each day. On Day 1 itself, the margin balance has gone below the maintenance margin of $750. It has reach $700 and the trader is required to deposit $300 to replenish the margin balance back to the original $1000. On day two, the price moved up creating a gain of $100. The margin balance at the end of day two is $1100. On Day 3 again, the price moves down by 30 cents. However, at the end of the day, the margin balance is $800, that is, above the margin balance. So, no margin call is required.

Margin Requirements in Futures Contracts

A trader who has a long or short position in a <a title="Characteristics of Futures Contracts" href="https://financetrain.com/characteristics-of-futures-contracts/">futures contract</a> can terminate the contract in four ways:

Closeout

This is the case where the futures trader closes out the futures contract even before the expiry. A trader who has a long position can take an equivalent short position in the same contract, and both the positions will be offset against each other. Similarly, a trader with a short position can take a long position in the same contract to closeout the position.

Delivery

On the settlement date, the short can settle the contract by delivering the underlying asset to the long. The contract is settled by delivery. This method is hardly used and constitutes not more than 1% of contract settlements.

In case of the physical delivery, the clearinghouse will select a counterparty for physical settlement (accept delivery) of the futures contract. Typically the counterparty selected will be the one with the oldest long position.

Cash Settlement

Cash settlement can be done only if the contract specifies so. The trader just leaves his position open and when the contract expires, his margin account will be marked-to market for P&amp;L on the final day of the contract. This is the most commonly used method as the trader saves on the transaction costs of closing out the position.

Exchange for Physicals

A contract can also be terminated through an exchange of physicals. In this case, a trader finds another trader who has an opposite position in the same futures contract and delivers the underlying assets to him. This happens outside the exchange floor, and is called an ex-pit transaction. The traders will then inform the clearinghouse about the transaction.

How Futures Contracts are Terminated/Settled?

In this article, we will discuss the characteristics and conventions for different types of futures contracts.

T-bill Futures Contracts
<ul>
	<li>Face value: $1 million</li>
	<li>Underlying asset: 90-day T-bills</li>
	<li>Quotation: 100 minus annualized discount rate</li>
	<li>Settlement: Settled in cash</li>
</ul>
Eurodollar Futures
<ul>
	<li>Face value: $1 million</li>
	<li>Underlying: 90-day LIBOR (add-on yield)</li>
	<li>Quotation: 100 minus annualized LIBOR(%)</li>
	<li>Settlement: Settled in cash</li>
	<li>Minimum price change: 1 tick ($25 per $1 million contract)</li>
</ul>
In Eurodollar futures, the long gains when interest rates decline, and vice verse.

Treasury Bond Futures
<ul>
	<li>Face value: $100,000</li>
	<li>Underlying: Treasury bonds with maturity greater than 15 years</li>
	<li>Quotation: Quoted as percent and fraction of 1% (1/32) of face value</li>
	<li>Settlement: Deliverable contracts</li>
</ul>
The short can deliver from many bonds that meet the delivery terms. Generally, the cheapest-to-deliver bond will be delivered. 

Stock Index Futures
<ul>
	<li>Face value: 250 times the level of index</li>
	<li>Underlying: Stock index</li>
	<li>Quotation: Index value</li>
	<li>Settlement: Cash settlement (in multiples of 250)</li>
	<li>Gain/loss: Each index point represents a gain/loss of $250 per contract</li>
</ul>
The above figures assume the example of S&amp;P 500 Index Futures.

Currency Futures
<ul>
	<li>Face value: Depends on the currency (A euro contract is on EUR 125,000). This is in the US with USD as the domestic currency.</li>
	<li>Settlement: Delivery</li>
	<li>Gain/Loss: A change of 0.0001 USD translates to $12.50 on a Euro contract.</li>
</ul>

Characteristics of Different Types of Futures Contracts

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