Futures and Forward Contracts

Futures and forward contracts are a way of trading interaction, in which you can not take into account the dynamics of the price of goods, since it is standard and does not change until the end of the contract. Simply put, you agree to buy the asset in the future at a fixed price, and if it changes due to market fluctuations, it will not affect your contract.

There is some difference between forward and futures contracts. At its core, this is one and the same, but there are special exchanges for futures trading, and all aspects of interaction are enshrined in a legal agreement. In addition, forward contracts are fully redeemed after the expiration of the term, and futures can then be extended in various ways.

For the first time, the idea that you can somehow protect yourself from price fluctuations in dynamically changing markets arose in the seventeenth century. However, primitive European futures markets were very different from modern ones. But the Japanese "rice exchange", which was created at the beginning of the 18th century, already worked according to all standard rules. True, rice was used as a means of payment, which at that time was used as a payment method.

Modern futures markets also operate not only in financial assets and currencies, but also in almost any commodity.

Why do you need futures contracts

This method of financial interaction provides users with a number of advantages:

  • Variety of assets. It is not necessary to physically store oil barrels in order to trade them in futures markets. Therefore, players in such markets can dispose of a huge amount of a wide variety of goods, securities and financial assets. This also applies to cryptocurrency.
  • Open prices. Thanks to the single market space, each market participant can at any time find out the real price of a particular product. It is also worth considering that futures prices are relatively stable, so they allow you to build long-term interaction strategies.
  • "Naked positions". This is a situation when a trader buys futures (guarantee obligation to provide goods) when he does not have this product. So during the indicated period, he is obliged to do something with this. Otherwise, he will receive sanctions and fines.
  • Leverage or financial leverage. The possibility of a kind of "loan." A simple example. A person who has a real 1000 dollars can use futures leverage 10: 1 to operate futures in the amount of 10,000 dollars. However, profit or loss is calculated precisely from the "large" amounts, so there is a big chance to lose a lot. Risk is increased, but also chances of success are increased too.
  • Hedging and risk management. If you conclude a contract for the supply of, for example, food for a certain amount now, then you can not fear the lack of demand in the future, price fluctuations and instability of the market in total.

Settlement mechanisms

In simplified form, futures are a guarantee obligation to provide goods at a certain price by a certain date. When this period comes, the contract is “canceled” and the participants in the exchange begin to settle. Two methods are commonly used.

  • Physical. The simplest option is the “short side” / seller transfers the goods to the “long side” / buyer. But speaking truly, less than 10 percent of all transactions in the futures markets end in this way.
  • In cash. Instead of physical exchange, using the cash equivalents which correspond to the real value of the goods at the time the transaction is completed. Most often, this method is used when working with assets that are technically difficult to exchange.

The second option is much more popular, since it is much easier to work with money equivalents than with real assets. Fortunately, the method of calculation is prescribed when concluding a futures contract.

However, there are shortcomings at this option too. The fact is that unscrupulous traders can manipulate the value of the goods, winding up or knocking it off by the time the trading is completed on the last day of the futures contract. This process is called "banging the close." However, in large futures markets it is quite difficult to implement.

Ends and exits from futures contracts

There are three main scenarios:

  • Execution of the contract. Both participants fulfil their obligations, one receives the goods, the second - money. A rather rare event - as already specified, less than 10 percent of contracts end in this way.
  • Reverse transaction. Something like "resale." If, for example, a trader has 30 purchase contracts (30 short positions), then he can open 30 similar long ones ending on the same day as short ones. This allows you to compensate losses or realize profits before the date of official completion of the contract.
  • Rollover or transfer position. A kind of "extension" of the contract. If the mentioned trader has all the same 30 long positions, then on the day of their completion he can sell them and immediately buy new ones, the period of which has been extended for the time period he needs. It is advisable to do this simultaneously, within the framework of one transaction. It is usually used in situations where the trader does not want to lose their market positions.

Futures Price Models

As already mentioned, during conclusion of a futures contract, the price is fixed at a certain level. However, the real price of the product may change over time, as can be seen on the corresponding chart.

  1. Contango. The situation when the market value of the contract is higher than the declared price
  2. Expected price or spot price. It is not always constant and in some cases can change, depending on the level of supply and demand.
  3. Normal backwardation. A situation when the current market price of a futures contract is lower than the spot price.
  4. Date of execution. The last trading day prescribed at the conclusion of the contract.

As you can see, the contango situation is more beneficial for sellers, and normal backwardation is more beneficial for buyers. It is also seen that the closer the contract execution date is, the smaller the difference between the expected and the real price is. If by this moment they still do not match, then dissatisfied traders can apply to the arbitration of the exchange to get instant profit.

Despite the fact that the contango situation is more profitable for sellers, it can also be useful for buyers. For example, in situations where the physical storage of assets is complex and expensive. In fact, the difference between the paid price and the spot price is a “storage charge". In addition, many companies buy in this way some of the goods that are required for their work in the future. For example, alcohol producers conclude contango futures for future wheat or corn crops.

Normal backwardation, in turn, can be beneficial for speculators who expect a predicted increase in the price of futures in the near future. Buy cheaper now to sell more expensive later.

Conclusion

Futures contracts are an extremely common tool in the financial industry. If you know how to use it, then you can physically get real profit without possessing a large number of real assets. And what is especially important - this tool works quite effectively with cryptocurrencies.

However, in some situations, especially when contracts are traded with a margin, a fixed price can lead to certain financial risks. Therefore, most traders use technical analysis to evaluate and plan their own activities.