Futures Contracts

Written by Aaron Adam

Although they're traded in a similar fashion to stocks, the truth is that a futures contract is an entirely different animal. In fact there are a variety of key differences between futures and various other financial instruments such as stock and options. It's important for investors in the futures markets to know and understand these differences, so they'll have a better grasp of what they're buying and selling.

Stocks represent equity in a company and can be held in perpetuity if the investor wishes. Futures contracts are different in that their lives are very finite. The contract sets a price for an asset to be delivered at a certain date. Once the period of the contract is up, it becomes worthless.

Unlike stocks, bonds, warrants and rights, futures contracts are not direct securities. Instead they are a type of derivative contract -- a financial instrument whose worth comes from some underlying asset. Instead of directly trading the underlying asset, derivative traders -- for our purposes, futures traders -- enter into an agreement to exchange money or other assets over time based upon the underlying asset.

Futures contracts are most commonly used for hedging commodity prices, that is protecting a party such as a producer or consumer of the underlying asset from fluctuations in the price of the underlying asset. A futures contract is essentially an agreement between two parties to deliver an underlying asset, such as oil or metal, at a set price sometime in the future. Third parties often buy and sell these contracts to make a profit on fluctuations in the price of the underlying asset.

It basically works like this, the buyer of the futures contract, that is, the party adopting a long position, will agree on a price at which he'll buy the underlying asset at some point in the future. The contract seller, that is, the party holding the short position, will agree to sell the underlying asset at the expiration date of the contract for the price set between the buyer and seller. During the time in which the contract is entered into and the date of deliver, the contract's value will fluctuate, thus creating either profits or losses for the investor trading futures contracts.

In many cases, actual delivery of the contract never takes place. The buyer and seller generally each liquidate their positions before the expiration date of the contract, with the buyers selling the futures and the sellers buying futures.

Futures contracts vs. options contracts

Futures contracts differ from options contracts in that a futures contract obligates the holder to make or take delivery of the underlying asset as per the terms of the futures contract. An option grants the buyer or seller the right, but not the obligation to make or take delivery of the underlying asset. Put simply, the holder of an options contract has the opportunity to exercise the contract, but does not have to. Futures contract holders must fulfill the contract on the expiration date of the contract.

The seller of the contract must deliver the underlying asset on the expiration date, or if it is a cash settled future contract, then money is moved from the trader who took a loss to the trader who made a profit. If a trader wants to get out of the commitment before the futures contract expires, he must offset his position by one of two means; selling a long position or buying back a short position.

How arbitrageurs make use of futures contracts

Arbitrageurs monitoring futures market look for discrepancies in the relationship between futures and cash to spot an opportunity to exploit mispricing. Arbitrageurs are essentially investors who seek to profit from inefficiencies in price in the market by making fast, simultaneous trades that compensate for one another, thus allowing the arbitrageur to make risk free profits.

For example, if an arbitrageur sees that oil futures in a certain time period were overpriced relative to the cash oil market or interest rates, the arbitrageur would move to sell the contracts with the understanding that he could secure a risk-free profit. Floor traders would take notice of the big volume in selling and react by swiftly deflating the futures price, thus bringing it back into equilibrium with the cash market for the underlying commodity.

These opportunities for profit are rare and must be quickly noticed and taken advantage of. The majority of arbitrage strategies are executed by large trading firms. Their arbitrageurs watch the prices in cash and futures markets carefully from a futures exchange and have various electronic communication equipment they use to place trades on the floor of the exchange.

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