When someone says futures, it means they are referring to a specific type of future contract traded in exchange such as crude oil, gold, silver, currencies, index futures, natural gas and equity futures.
We have different types of financial markets in the world. Markets are named based on the type of financial securities traded in it.
Major financial markets are; Forex, Equity, and Commodities.
A future market is a marketplace where future contracts are bought and sold by participants.
Future contracts are derivatives that lock in future delivery of an underlying asset such as commodity, stock, currencies or security at a fixed price set today.
In other words, a future market can be defined as an exchange (auction market) in which agreements to buy or sell a particular security at a fixed price at a specified time in future are traded.
The fundamental difference between a spot or cash market and future market is that in the case of buying futures you are not taking immediate delivery, whereas in a cash market you take immediate delivery of the stock or other security.
Examples of futures markets are the New York Mercantile Exchange (NYMEX), the ICE, Eurex and the Chicago Mercantile Exchange (CME).
In the US, future markets are regulated by the commodity futures trading commission (CFTC).
In India, we have three major players offering trading in future contracts, they are National Stock Exchange (NSE), BSE and Multi Commodity Exchange of India Limited (MCX). These exchanges and the future market are regulated by Securities and Exchange Board of India (SEBI).
In NSE and BSE, you will find stock, currency and index futures.
In Multi Commodity Exchange of India Limited (MCX), commodity futures such as crude oil, agricultural commodities, natural gas, gold, and silver are traded.
How does the future market work?
Future contracts are generally created to avoid market volatility. Future contracts are traded in exchanges for delivery at some agreed upon date in the future with a fixed price at the time of deal.
Futures contracts give the producer or supplier of a commodity an opportunity to avoid market volatility.
Both the parties of a future contract agree to take on both the risk and reward of market volatility.
Options and futures are both derivative contracts. Which means, these financial instruments derive their value from an underlying asset or instrument.
An option contract provides the holder the right, but not the obligation, to buy or sell an asset at a fixed price on a predetermined date. The maximum risk to the holder of the option is limited to the premium paid.
However, a future contract is a binding agreement. Both buyer and seller agree to buy or sell the underlying asset or financial instrument at a specific price at a predetermined date.
One of the biggest advantages of the future over options is time decay. Options are considered as wasting assets as value of these assets decline over time, which is also termed as time decay.
Example to understand future market
Suppose the current market price of crude oil is $83 per barrel to an oil importer. The oil producer is planning to produce 0.5 million barrels over the next 6 months.
The oil producer has two choices: produce and sell it at the current market prices 6 months from today or opt to lock in the price now.
If the oil producer thinks that the market price will go up by the time they produce the crude oil, then they will never opt to lock in the price now.
But, by looking at the current market volatility, if they think that the price may go down, then they might prefer to lock in $ 83 per barrel or any better price as a future price.
When both the investor and oil producer agree to a price, suppose $ 83 per barrel, they have agreed that in 6 months the producer will deliver 0.5 million barrels of crude oil and the guaranteed fixed price is $83 per barrel. Regardless of the spot price, oil producers are guaranteed to get $83 per barrel.
How future contracts are settled?
Most of the future contracts are cash settled.
In cash settlement, the trader will pay or receive a cash settlement depending on how the underlying asset has performed. Equity index futures are cash settled.
In certain cases, future contacts require physical delivery.
Who is trading in the future market?
We have two types of traders: speculators and hedgers.
Speculators bet on the future price movement of underlying assets by buying and selling future contracts.
Hedgers use future contracts to lock in future prices in order to avoid market volatility. Hedgers are like agri farmers, miners, suppliers and producers who want to lock in price now without having to worry about future price changes in the market.
