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Financial Futures

Financial futures are derivative instruments that may seem complex at first, but once you understand how they work, you'll discover they are a powerful tool for investing, hedging risks, and speculating. In this article, we will explain what futures are, what they are used for, where they are traded, and what aspects you should consider when trading them.

What Are Futures?

A future is a financial contract that obligates the involved parties to buy or sell an underlying asset at a predetermined price on a specific future date. Futures are traded in organized markets and have standardized contract conditions, such as size, expiration, and the underlying asset.

Underlying Assets

Futures can be based on:

  • Commodities: Such as oil, gold, uranium, wheat, or coffee, but also others like natural gas, cotton, sugar, corn, cocoa, orange juice, and industrial metals like copper and aluminum, which are essential in various industries.
  • Financial assets: Such as stock indices, currencies, bonds, or interest rates.

What Are Futures Used For?

Futures have several uses depending on the goals of the investor or company:

  1. Hedging risks: Companies and farmers use them to protect against price fluctuations. For example, an airline may buy oil futures to lock in a fixed fuel price.
  2. Speculation: Traders take advantage of price changes in futures to make profits without intending to own the underlying asset.
  3. Diversification: Including futures in a portfolio allows access to markets that would otherwise be difficult to reach.

Where Are Futures Traded?

Futures are traded on organized markets called futures exchanges. Some of the most important include:

  • CME Group (Chicago Mercantile Exchange): The global leader in futures contracts on indices, currencies, and commodities.
  • Euronext: Popular in Europe for futures on stocks and bonds.
  • ICE (Intercontinental Exchange): Specializes in energy and commodity futures.

These exchanges ensure that contracts are fulfilled through clearinghouses that eliminate counterparty risk.

Key Aspects When Trading Futures

1. Contract Size

Each contract has a standard size. For example, an oil futures contract may represent 1,000 barrels, while a gold futures contract may represent 100 ounces.

2. Initial Margin and Maintenance Margin

To trade futures, you need to deposit an initial margin, which is a percentage of the total contract value. You must also maintain a minimum balance called the maintenance margin to cover potential losses.

3. Expiration Date

Futures have a deadline for execution. You must decide whether to close your position before this date or accept the delivery of the asset (in the case of physical futures).

4. Leverage

Leverage allows you to control large positions with a small investment. This amplifies both gains and losses, so risk management is crucial.

5. Settlement

Futures can be settled in two ways:

  • Physical: The underlying asset is delivered, such as barrels of oil.
  • Financial: The difference between the agreed price and the market price is paid.

Common Strategies with Futures

  1. Hedging: Companies lock in fixed prices for critical inputs or final products.
  2. Spread Trading: Taking advantage of price differences between two futures contracts on the same asset with different expiration dates.
  3. Day Trading: Buying and selling futures on the same day to capitalize on small market movements.

Advantages and Disadvantages of Futures

Advantages:

  • Transparency: Prices are negotiated in regulated markets.
  • Liquidity: Some futures, such as those for oil or indices, have high liquidity.
  • Leverage: Allows for maximizing the use of capital.

Disadvantages:

  • High risk: Leverage can result in significant losses.
  • Complexity: Requires a good understanding of the market.
  • Additional costs: Commissions and margins can affect profits.

Glossary of Terms

  1. Underlying Asset: The asset on which the futures contract is based (e.g., oil, gold).
  2. Initial Margin: Deposit required to open a position in futures.
  3. Maintenance Margin: Minimum amount needed to keep a position open.
  4. Leverage: Using borrowed funds to increase market exposure.
  5. Physical Settlement: Delivery of the underlying asset upon contract expiration.
  6. Financial Settlement: Payment of the difference between the contract price and the market price.
  7. Clearinghouse: Entity that ensures the fulfillment of futures contracts.
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