What Are Futures?
Futures contracts are firm commitments to make or accept delivery of a specified quantity and quality of a commodity during a specific month in the future at a price agreed upon at the time the commitment is made. The buyer, known as the long, agrees to take delivery of the underlying commodity. The seller, known as the short, agrees to make delivery. Only a small number of contracts traded each year result in delivery of the underlying commodity. Instead, traders generally offset their futures positions before their contracts mature (a buyer will liquidate by selling the contract, the seller will liquidate by buying back the contract). The difference between the initial purchase or sale price and the price of the offsetting transaction represents the realized profit or loss.
Futures contracts trade in standardized units in a highly visible, extremely competitive, continuous open auction. In this way, futures lend themselves to widely diverse participation and efficient price discovery, giving an accurate picture of the market.
To do this effectively, the underlying market must meet three broad criteria: The prices of the underlying commodities must be volatile, there must be a diverse, large number of buyers and sellers, and the underlying physical products must be fungible, that is, products are interchangeable for purposes of shipment or storage. All market participants must work with a common denominator. Each understands that futures prices are quoted for products with precise specifications delivered to a specified point during a specified period of time.
Actually, deliveries of most futures contracts represent only a minuscule share of the trading volume; less than 1% in the case of energy. Precisely because the Exchange's physical commodity contracts allow actual delivery, they ensure that any market participant who desires will be able to transfer physical supply, and that the futures prices will be truly representative of cash market values.
Most market participants choose to buy or sell their physical supplies through existing channels, using futures or options to manage price risk and liquidating their positions before delivery.
Why Use Futures Contracts?
The contracts are standardized, accepted, and therefore liquid financial instruments.
The exchange offers cost-efficient trading and risk management opportunities.
Futures contracts are traded competitively on an exchange in an anonymous auction, representing a confluence of opinions on their values.
Exchange futures and options prices are widely and instantaneously disseminated. Futures prices serve as world reference prices of actual transactions between market participants.
The exchange's markets allow hedgers and investors to trade anonymously through futures brokers, who act as independent agents for traders.
The liquidity of the market allows futures contracts to be easily liquidated prior to required receipt or delivery of the underlying commodity.
While futures contracts are seldom used for delivery, if delivery is required, there is a system of safeguards in place to secure financial performance. Unlike individual transactions with a counterparty which must be continually examined, counterparty credit risk is mitigated by a strong set of guarantees and the financial safety of the exchange clearing house and the major financial service firms which are clearing members (see below).
Futures contract performance is supported by a strong financial system, backed by the exchange's clearing members, including the strongest names in the brokerage and banking industries.
The exchange offers safe, fair, and orderly markets protected by its rigorous financial standards and surveillance procedures.
The exchange provides buyers and sellers with price insurance and arbitrage opportunities that can be integrated into cash market operations.
Trading exchange contracts can improve the credit worthiness and add to the borrowing capacity of natural resource companies, thus augmenting the companies' financial management and performance capabilities.
Cash and Futures Price Relationships
Cash prices are the prices for which the commodity is sold at the various market locations. The futures price represents the current market opinion of what the commodity will be worth at some time in the future. Under normal circumstances, the price of the physical commodity for future delivery will be approximately equal to the present cash price, plus the amount it costs to carry or store the commodity from the present to the month of delivery. These costs, known as carrying charges, determine the normal premium of futures over cash.
As a result, one would ordinarily expect to see
an upward trend to the prices of distant contract
months. Such a market condition is known as "contango" and is typical of many futures markets. In most physical markets, the crucial determinant of the price differential between two contract months is the cost of storing the commodity over that particular length of time. As a result, markets which compensate an individual fully for carry charges, interest rates, insurance, and storage are known as full contango markets, or “full carrying charge” markets.
Under normal market conditions, when supplies are adequate, the price of a commodity for future delivery should be equal to the present spot price plus carrying charges. The contango structure of the futures market is kept intact by the ability of dealers and financial institutions to bring carrying charges back into line through arbitrage.
Futures markets are typically contango markets, although seasonal factors in energy markets play an important role in market relationships. For example, during the summer, heating oil futures are often in contango as users build up stocks ("inventory") for the approaching cold weather. On any given day, prices in the forward contract months are progressively higher through the fall, reflecting the costs of storage, interest rates, and the assumption of increased demand.
The opposite of contango is "backwardation", a market condition where the nearby month trades at a higher price relative to the outer months. Such a price relationship usually indicates a concern with supply; a market can also be in backwardation when seasonal factors predominate.
Convergence
As a futures contract approaches its last day of trading, there is little difference between it and the cash price. The futures and cash prices will get closer and closer, a process known as convergence. Any premium the futures have will disappear over time. A futures contract nearing expiration becomes, in effect, a spot contract.
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