A futures contract is an agreement to make delivery (to sell) or to take delivery (to buy) a specified amount and specific grade or quality of a commodity at a set price at a future date.
- For example, you’ve header of Treasury futures, gold and silver futures, corn futures, pork bellies, etc.
- Futures contracts are basically used for two broad purposes:
- Hedging is taking a temporary position in the futures market to offset a cash market position in order to minimize loss due to price fluctuation.
- This risk transfer mechanism allows hedgers to control costs and protect their profit margins.
- The parallel movement (in opposite directions), will not exact, is close enough to make it possible to minimize risk by hedging.
- Hedging is the primary justification of the futures market.
- Speculators assume the risk transferred to them by the hedgers.
- Motive to profit.
- They provide an essential element to market-place and that is liquidity.
How futures work?
Futures contracts are standardized. All contract features are established. For example, in a US T-bond future, the yield, maturity, quantity, delivery dates, etc., are established.
The only negotiable variable is price, which is determined by open outcry on organized and regulated markets or electronically matched on systems.
When entering into a futures contract, you must post an initial margin, which is like a security deposit to ensure performance.
- Initial margin is generally 3% to 10% of the contract value.
- All futures contracts are marked to market, with gains and losses settled daily.
- If losses deplete the initial margin below a certain point, you may be required to post a variation margin to bring your deposit back up to the original predetermined level.
To enter into a futures contract, you would place an order (and margin deposit) with a brokerage house or futures commission merchant, who also posts margin with the exchange and executes the order on the exchange through a floor trader.
Foor traders give complete orders to clearing firms who are members of the exchange’s clearing house or clearing corporation.
Role of the clearing house
The clearing house provides several functions:
- It matches all orders and interposes itself between each buyer and seller, which guarantees the integrity and performance of all contracts.
- It balances its books to zero, settling all gains and losses. Each day begins with no money owed and no money due.
- It future positions are still open at expiration and physical delivery is to occur, the clearing house assigns delivery to the clearing member having the oldest position. For example, if a short position is open and the short seller indicates its intention to deliver a security rather than close out its contract, the clearing house will determine the buyer based on the oldest long position in that contract.