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Read This to Understand Futures

Futures

Background

As a division of derivatives, futures have much in common with others in this category, otably options.

Futures may play a valuable function for both producers and consumers alike. For consumers, establishing a price on a commodity through a futures contract guarantees that the listed price on the contract will hold up at a later date even if the market value of that good declines. In other words, a futures contract may serve as insurance for those people.

On the other hand, some consumer investors may be looking to take more of a gamble on the welfare of a chosen underlying asset and will look to trade futures as part of an exchange. In this scenario, investors will first buy a futures agreement at the strike price, and hope that the asset will rise in worth, yielding a net gain upon its sale. Just as easily, however, it could fall in value, resulting in an opposite, negative effect.

Futures Contract Specifics

There is more to futures contracts than simply listing an underlying asset and its price. Indeed, futures can be rather complicated when push comes to shove. In terms of specific details, there must be a time frame by which holders must make a transaction regarding the underlying asset, known as the delivery month. Otherwise, they could theoretically sit on their investment ad infinitum, essentially converting it into an option.

The delivery month (and year) are included in coded references to the contract, as well as the commodity chosen for the basis of the accord. There is also the matter of a margin to be paid to the futures seller upfront. Though usually no more than 10% of the market value of the underlying asset, the margin is still a serious monetary commitment for the sake of investments.

Based on the inclusion of a margin and other aspects therein, a futures contract is significantly different from the average forward contract. While both are classified as derivatives, the prices and standards of trading certain commodities in futures contracts are established by futures exchanges administration. Futures contracts, quite literally, are exchange-traded derivatives. Forward contracts, on the other hand, are bought and sold "over the counter," and thus are not agreed upon in exchanges, but as part of private agreements.

Long vs. Short Position

By virtue of their choice to be either a buyer or seller in the futures market, investors are either taking a long or short position with regards to futures trading. In going short or long on futures, one is taking a sure but calculated risk, in essence, making a wager on the eventual outcome of the underlying asset.

A short seller borrows against the face value of the underlying asset and sells the contract, only to buy back a similar property at a lower price, ultimately coming out ahead. With the long position, meanwhile, the objective is notably simpler: to sell the future when it increases in value, thereby using a "buy-low-sell-high" rationale to turn a profit. Thus, very basically, one in the short position anticipates a drop in the underlying asset's value, while one who goes long expects the opposite.

In fairness, both strategies have their inherent risks. Concerning the long position, if futures fail to rise above the strike price, or worse, fall under it, at most they will lose the face value on the contract. Appropriately, this is the safer and far more frequent choice for the securities investor.

Consequently, the short position is recommended only for experienced traders and brokers and/or those with the capital to support a risky business venture. If, by the maturity date, the underlying asset multiplies in value, the investor will be forced to buy at that value. Thus, while a long seller will stand to lose no more than the strike price, the short seller's potential losses are boundless.

Futures Options

Though most commonly futures are the contracts in which commodities are the underlying assets, in futures options the option is the financial instrument and contract and the future contract serves as the underlying asset. While this special arrangement of sorts may be disorienting to some (especially if they have no familiarity with either type of derivatives), for the most part a futures option (a.k.a. option in futures) behaves just like any normal option would.

Sellers, banking on an overall reduction in the value of the underlying futures contract, will charge a premium to buyers so that they (the buyers) may secure the rights to the contract whereupon the now-holders are anticipating the contrary to ensue.

Then again, this depends on the type of option the investor invokes. The above scenario is characteristic of the call option.

Futures Exchanges

A potential buyer or seller of commodities cannot do anything without a forum in which to do business, so to speak. As far as trading futures contracts goes, this forum is known as a futures exchange. Futures exchanges, among other things, create a secure environment for transactions of these financial instruments that runs according to standard values of the underlying commodities and federal standards for conduct.

It should be noted that it is not as if agreements created through exchanges are forged by the eventual transactional parties themselves. Instead, the futures contract is a proverbial blank check to be signed whose rate of exchange will be locked in upon acceptance.

Trading futures through exchanges is decidedly risky, for reasons other than general security issues. Primarily, the concern of financial experts for investors' sake is that huge shifts in the value of one's future in possession—often for the worse—can result from proportionately minor changes in the values of goods and/or the indexed rate of futures as a whole.

Still, futures remains a sought-after and perhaps lucrative pursuit for some. Among the prominent exchanges known nationally and internationally are the CME Group, based largely in Chicago, and the International Securities Exchange, a subsidiary of Eurex.

Futures Brokers

Whether their spare time to devote to managing their securities is slim or they are simply fearful of getting involved with the futures market, prospective investors likely stand a better chance in finding success with these financial instruments if they enlist the help of a futures broker.

In soliciting the services of a futures broker, individuals are signing up for two major functions. The first is that the broker will handle one's investments and directly interact with the relevant parties at exchanges to try to affect transactions.

The second function, which actually goes into the initial transaction, is to use the sum of his or her knowledge and experience within this field to the client's advantage, and for a commission, earn the investor money back and then some on his or her opening purchase. Though it should go without saying, one should be careful when dealing with futures brokers and brokerage firms.

Commodity Futures Trading Commission

Working with a futures broker only works to people's advantage if said professional is acting in their best interests. In an effort to hold broker-dealers to a higher standard when it comes to the fairness and effectiveness of their practice, the nation's primary line of defense, as far as futures go, is the Commodity Futures Trading Commission, or CFTC.

Created by Congress in the 1970's, the CFTC is nominally affiliated with the Federal Government as an independent agency and is separate from the Securities and Exchanges Commission (SEC). The scope of the CFTC's regulation, though confined to futures and options, still exceeds what it encompassed at the Commission's incipient stages.

Broadly, the CFTC is concerned with preserving some of the key ideals in the American marketplace as a whole, namely the concepts of fair commerce and the free flow of capital as a stimulus for the economy. In tackling the fairness aspect of futures trading, the CFTC responds to allegations of fraud, abuse and other misdeeds on the part of brokers and emphasizes the necessity of full disclosure by professionals in dealing with consumer investors.

Through its partnerships with IOSCO, CESR and other international organizations, the Commission also keeps an eye on the inter-relatedness of U.S. and foreign exchanges.

NEXT: What are the Available Futures Options

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