Future Trading

Investing in futures contracts includes futures trading of traditional physical and agricultural commodities as well as a vast array of financial instruments, including U.S. and foreign government securities, foreign currencies, and U.S. and foreign stock indices.  New products were recently made available such as E-mini stock indices.  With the development of technology and the Internet, the ability for an investor to access information quickly and to execute transactions cheaply and rapidly online has added to dramatic growth of this futures market.

A futures contract is typically used to assume or shift price risk.  It is a commitment an investor makes to purchase or sell an underlying asset (“underlier”) for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; and (3) that may be satisfied by delivery or offset.  Offset is to make the opposite, or offsetting sale or purchase of the same number of contracts bought or sold prior to the expiration date of the contract.  In other words, you may contractually agree as an investor to purchase or sell an asset as diverse as lumber or French Francs, at some specific time designated in the future.  Futures offer a convenient tool for hedging or speculation that require little or no initial cash outlay and no need for you to immediately pay for, hold or warehouse the underlying asset.  So you don’t have to own lumber or French Francs or even buy these assets to enter in this transaction. 

Futures can be purchased through a stock broker or through a commodities brokerage.  My suggestion is to go with an expert in the field--a commodities brokerage.  This could be a discount brokerage or online futures broker.  There are several online futures trading and discount futures brokers.  To enter into a futures contract, you must make a deposit called initial margin with a broker. The deposit may be cash or acceptable securities. This deposit is held by the broker for you in a margin account and, in the case of a cash deposit, pays interest on the balance. The amount of initial margin is determined according to a formula set by the exchange

A futures contract is created when two parties negotiate a (through their respective brokers) a futures transaction.  The transaction is actually structured as two contracts.  The buyer and seller each enter in a contract with the future exchange's clearinghouse. In this way, the parties are not exposed to each others' credit risk. There is credit risk between the respective parties and the clearinghouse, but the required margins largely eliminate this risk.  The clearinghouse always takes offsetting positions, so it does not incur market risk.

The obligation of a futures contract can be met in one of two ways. An investor may make or take delivery of the actual “underlier” in exchange for the price specified on the contract.  However, physical settlement is by far the exception, not the rule. Less than 2% of all futures contracts are settled with an actual delivery.  On the other hand, a cash settlement occurs when the “underlier” is not physically delivered. Instead, the contract is settled for an amount of money equal to what the “underlier’s” market value would be at maturity/expiration if it were a physically settled.  In this case the investor makes the opposite (or offsetting) sale or purchase of the same number of contracts bought or sold sometime prior to the expiration date of the contract. Because futures contracts are standardized, this is accomplished easily.

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