Futures - An Introduction

Futures and options trading is a popular financial vehicle for both hedgers and speculators throughout the world, with contracts traded on a wide variety of commodities, and financial indexes. For hedgers, exchange-traded futures and options provide several important economic benefits, including the ability to shift or otherwise manage the price risk of the underlying cash markets.

For speculators, these markets provide a vehicle to potentially profit from these price fluctuations.

Futures markets are among the most liquid of all global financial markets, providing low transaction costs and ease of entry and exit. This, in turn, fosters their use by an array of business enterprises and investors to manage their price risks. And the savings resulting from effective risk management can be passed on to the final consumers of the commodities, currencies and financial instruments that underlie the futures and options contracts.

Today's futures industry functions with a number of time-tested institutional arrangements, including clearinghouse guarantees and exchange self-regulation. Futures and options markets also reflect a tradition of innovation and growth, with new products, new exchanges and record trading volumes appearing each year. And while the U.S. markets have continued their pattern of steady expansion, recent increases in trading activity have been most pronounced outside the United States in the newer markets of Europe, Asia, Australia and Latin America.

Historically, futures market participants have been divided into two broad categories: hedgers, who seek to reduce risks associated with dealing in the underlying commodity or security, and speculators (including professional floor traders), who seek to profit from price changes. More recently, a new category of participant has emerged, the portfolio manager who uses futures and options as essential elements of portfolio management. For speculators, the attraction of futures markets includes their leverage, the diversification they add to a portfolio, the ease of assuming short as well as long positions, and the low cost of market entry and exit. Speculators and market-makers assume the risk transferred by hedgers and provide the liquidity that assures low transaction costs and reliable price discovery in futures markets.

Hedging is central to futures and options markets, and a familiarity with hedging practices is necessary to understand how these markets work. In simplest terms, hedgers:

Identify their price risk,

Decide how much to hedge,

and Decide where and how to hedge.

In futures markets hedging involves taking a futures position opposite to that of a cash market position. That is, a corn farmer would sell corn futures against his crop; an importer of Japanese cars would buy yen futures against her yen liability; a precious metals merchant would purchase gold futures against a fixed-price gold sales contract; and a pension fund manager would sell stock index futures against the fund's portfolio of equities in anticipation of a market decline.

Examples of the types of risk - management activities that rely on the use of futures include:

Stabilizing cash flows;

Setting purchase or sale prices of commodities and securities;

Diversifying holdings;

More closely matching balance sheet assets and liabilities;

Reducing transaction costs;

Decreasing costs of storage;

and Minimizing the capital needed to carry inventories.

 

Options

Options on futures are traded on the same exchanges that trade the underlying futures contracts and are standardized with respect to the quantity of the underlying futures contracts (by custom, one futures contract), expiration date, and exercise or strike price (the price at which the underlying futures contract can be bought or sold).

Most futures exchanges also provide the opportunity to participate in options trading.