Learn how to trade futures with our futures trading guide. You will also find an up-to-date list of regulated futures brokers from our team of experts.
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What is a futures contract?
We define a futures contract as a legally binding agreement whereby two parties agree to exchange an underlying asset (physical or financial) for a pre-agreed price at a specified future date.
The main reason for the two parties to pre-price an asset is to hedge against extraordinary future circumstances that may adversely affect either party, the seller or the buyer.
As detailed below, the first futures contracts in history were on agricultural commodity prices. Over the years, futures have evolved enormously and it is now possible to trade futures as financial assets.
Introduction to futures and options markets
The origins of futures contracts date back to ancient Egypt, where farmers could agree in advance on a price at which they would eventually sell their agricultural produce to a particular buyer. This was intended to cover their backs and reduce the risk of a bad harvest ruining their business. Later in 1687, in Samurai Japan, the Dojima rice exchange was created to trade rice futures.
Already in the 19th century, the creation of the CBOT (Chicago Board of Trade) and the Chicago Futures Exchange laid the foundations for the expansion of the use of futures contracts. Even so, for decades, the main assets included in these contracts continued to be agricultural products, although other commodities such as cotton and coffee were now included.
Over the years, futures markets would appear and, with them, the definitive global expansion. Today it is possible to trade agricultural futures, metals, currencies, bonds, etc. and there are futures markets in places as diverse as the United Kingdom, the United States, Japan, Singapore and New Zealand. At the same time, protection agencies were created to ensure the correct use of futures contracts, the most important of which is the CFTC (Commodities and Futures Trading Commission).
Types of futures contracts
As mentioned above, there are now a multitude of asset classes that can be included in futures contracts, which gives rise to as many different futures contracts that one can find in the major futures markets. Here we will list the most commonly used ones:
- Foreign exchange futures
- Agricultural futures
- Energy futures
- Metal futures
- Stock index futures
- Interest rate futures
How futures contracts work
A Futures Contract is a financial derivative in the form of a binding agreement. This means that the two parties, buyer and seller, agree to a future transaction at a price set at the time of sealing the contract and commit to exchange the underlying asset. In short, the future is a “buy now but pay and take it later” type of agreement.
Taking such an example, payment for the asset is not made when the futures contract is signed but on the maturity date of the contract. Similarly, the asset does not come into the possession of the buyer until the date stipulated in the contract. This can generate both profits and losses as the transaction will be carried out as stipulated in the future regardless of market developments.
Take for example an agricultural machinery exporting company that exports abroad on a quarterly basis. It can agree with a brokerage firm to sell the foreign currency at a certain price in three months’ time, when it receives payment for the exported equipment. Regardless of the evolution of the quotation of the different currencies, the transaction will be carried out as reflected in the futures contract.
There is an organised futures market called MEXDER which allows the purchase and sale of contracts before their expiry date. It is therefore possible to trade futures and speculate on the positions included in the contracts.
Difference between futures and options
If we look at the definition of these two terms, differentiating between futures and options will be very easy and we can start trading both.
- Futures: a binding contract whereby two parties agree to exchange a specified asset on a specified date.
- Options: A contract in which one party acquires the right to buy or sell an underlying asset within a specified period of time.
Therefore, one of the main differences is the obligation to carry out the transaction if we are talking about a futures contract, while with options the right is acquired but not the obligation to carry out the exchange. Another detail is the functioning of the dates, as options expire on the expiry date while futures are executed on the date reflected in the agreement.
Differences when trading futures and options
- Contract size: The contract size tends to be larger for futures contracts and therefore the margins for futures trading tend to be larger than those for options.
- Premiums: Trading options involves the payment of a premium over and above the usual trading commissions. The premium payment can be from seller to trader or vice versa.
- Obligation: Both parties to a futures contract are obliged to execute it on the expiry date. This is not the case for options contracts.
- Expiry date: option contracts expire on a specified date with no need to be exercised in advance.
- Trading futures and options: Futures traders will generate profit from the difference between the entry and exit price of the underlying asset. Options traders, in some cases, may be able to make a profit from premiums alone.
Differences between Futures and Contracts for Difference
It is possible to trade a multitude of financial assets in different forms, whether it be CFDs, futures, options, etc. It is therefore important to understand the definition of each of them and to know how to differentiate between them, as each derivative requires a different investment strategy due to its own nature.
As with options, Contracts for Difference do not involve an obligation to enter into a transaction. As mentioned earlier on this page, futures oblige both parties to enter into a transaction.
The liquidity of CFDs is usually higher than that of futures contracts because CFD brokers act as market makers. On the other hand, futures allow you to benefit from lower commissions on large-scale trades.
For all these reasons, futures contracts are generally chosen for large capital investments while Contracts for Difference are better suited to investors working with smaller amounts of capital.
Differences between futures and forwards
Futures and forwards have aspects in common, the main one being the obligation to carry out the transaction. However, it is worth mentioning these substantial differences between futures and forwards:
- Secondary market: There is a secondary market for futures but not for forwards.
- Standardisation: Futures are standardised in terms of maturity date and size. In forwards, this is determined by the transaction.
- Guarantees: The two parties to a forward provide collateral for the contract while futures enjoy institutional collateral.