What Are Futures and How Do They Work? Futures are financial derivatives that bind the parties to trade an item at a fixed price and date in the future. Regardless of the prevailing market price at the expiration date, the buyer or seller must purchase or sell the underlying asset at the predetermined price.
How do you interpret futures market prices?
- Change: The difference between the current trading session’s closing price and the previous trading session’s closing price. This is frequently expressed as a monetary value (the price) as well as a percentage value.
- 52-Week High/Low: The contract’s highest and lowest prices in the last 52 weeks.
- Each futures contract has a unique name/code that describes what it is and when it will expire. Because there are several contracts traded throughout the year, all of which are set to expire, this is the case.
Do futures pricing reflect stock prices?
Stock futures are more of a bet than a prediction. A stock futures contract is an agreement to buy or sell a stock at a specific price at a future date, independent of its current value. Futures contract prices are determined by where investors believe the market is headed.
Is the price of a futures contract a forecast?
Futures market prices can occasionally be used as spot price estimates. They don’t in other circumstances. The federal funds futures market, for example, can be used to forecast interest rate adjustments by the Federal Open Market Committee (FOMC). When making a soybean production loan, a bank loan officer should not rely solely on soybean futures prices to estimate future spot prices. To make matters even more complicated, a company that wants to estimate oil prices six months from now can occasionally rely on the futures market for a realistic forecast, but it can sometimes fail to do so.
To accommodate for these various eventualities, commodities must be divided into three categories: non-storable, storable with significant inventory “overhangs,” and storable with modest stocks.
Non-storable Commodities
Non-storable commodity futures prices reflect merely market projections of future supply and demand situations. These are the only commodities for which futures prices may be used as easy forecasting tools. Non-storable commodities are perishables, or items that vary in quantity or quality frequently. Eggs, for example, are considered non-storable because they spoil quickly; a fresh egg is not the same as an egg that has been sitting in the refrigerator for a month.
Non-storable commodity futures prices might differ dramatically from spot prices due to anticipated changes in supply or demand. Assume the market anticipates a decrease in egg supply in three months. The price of three-month futures would rise above the current spot price. Because vendors cannot keep the eggs (take them out of the spot market) to sell later, spot pricing would be unaffected. They have to sell today’s eggs at today’s market prices. In contrast, if the market expects egg production to rise in the next three months, the futures price will fall below the unchanged spot price.
There is also a futures market for federal funds, as well as an interbank market for reserves (deposit balances held by banks at the Federal Reserve). Because a bank cannot store reserves today to meet future reserve requirements, these products are non-storable. Federal funds futures pricing can be used to infer market expectations for future interest rate changes by the FOMC. 2 Current federal funds market conditions have no bearing on future conditions, and vice versa.
Storable Commodities with Large Inventories
Futures prices simply represent the current spot price plus carrying costs for storable commodities with huge inventory overhangssay, several months’ worth of consumption. Carrying costs are the interest and storage fees that would be incurred if the commodity were retained in inventory between the current date and the maturity date of the futures contract. For example, the market price for soybeans on November 1, 2001 was $4.26 per bushel, but the January 2002 futures quote on November 1 was $4.34.3. The eight-cent difference represents the per-bushel carrying costs of soybeans for two months.
Why are carrying costs required to link spot and futures prices? If the soybean futures price was higher than the spot price by more than carrying costs, an arbitrageur could make a guaranteed profit by selling a soybean futures contract, borrowing money to buy soybeans in the spot market, and delivering the soybeans to the futures contract buyer on the settlement date. A risk-free profit would be guaranteed because the difference between the futures price received and the spot price paid would more than cover carrying costs. If the futures price went below the spot price plus carrying costs, market players would sell their inventories in the spot market and buy futures contracts, putting downward pressure on the spot price while simultaneously increasing upward pressure on the futures price. As a result, traders seeking risk-free profit opportunities would soon return spot and futures prices to the above-mentioned relationship: The spot price plus carrying expenses will be the futures price. Traders, in effect, distribute the vast existing inventory across time, based on the cost of carrying inventory.
Storable Commodities with Modest Inventories
For storable commodities with low current stockpiles compared to current consumption needs, interpreting futures pricing is a little more difficult. We must distinguish between two scenarios in these marketplaces. The non-storable commodities analysis is used when futures prices are lower than spot prices (a pricing structure known as backwardation). The futures price is the market’s prediction of the spot price in the future. The study of storable commodities with substantial stockpiles applies if futures prices are higher than spot prices (a contango market).
The oil futures market is an excellent example of a storable commodity with low inventory levels. If the supply of oil is predicted to increase in the future, then futures prices will fall relative to spot prices. Although arbitrageurs might potentially benefit by selling oil on the spot market when the spot price is greater than the futures price, inventory shortages prohibit this. The spot price for a barrel of crude oil on November 1, 2001 was $21.70; the November 2002 futures price was $21.27.4 An arbitrageur could clearly profit by selling spot oil in 2001 before the price drops, but inventory limitations prohibit this.
If, on the other hand, future supply is predicted to be limited, future spot prices are expected to be higher than present spot prices. Arbitrageurs might buy “cheap” spot oil with borrowed money, sell oil futures contracts, and store the oil for future delivery, so the futures price could not soar arbitrarily high above today’s spot price. The arbitrageur pushes the spot price higher and the futures price lower by taking advantage of projected high future prices and the storability of oil. This is the same issue we discussed earlier for commodities with substantial inventory overhangs. The gap between the futures and spot prices represents only the carrying costs in this scenario, not the market’s estimate of future spot prices. As a result, futures market pricing for storable commodities with relatively small inventory overhangs must be viewed with caution.
What causes the price of futures to rise?
Assume that excellent news arrives overnight from abroad, such as a central bank cutting interest rates or a country reporting stronger-than-expected GDP growth. Local equities markets are likely to climb, and investors may expect a higher U.S. market as well. The price of index futures will rise if they buy them. Nobody will be able to counterbalance the buying demand even if the futures price exceeds fair value since index arbitrageurs are sitting on the sidelines until the U.S. stock market opens. The index arbitrageurs, on the other hand, will execute whatever trades are necessary to bring the index futures price back in line as soon as the New York Stock Exchange opensin this case, purchasing component stocks and selling index futures.
How are futures traded?
A futures contract is a contract to purchase or sell an item at a predetermined price at a future date. Soybeans, coffee, oil, individual stocks, ETFs, cryptocurrencies, and a variety of other assets could be used. Futures contracts are often traded on an exchange, with one side agreeing to buy a specific quantity of securities or commodities and take delivery on a specific date. The contract’s selling party agrees to provide it.
What is the distinction between the Dow and the Dow futures?
A Dow Future is a contract based on the Dow Jones Industrial Average, which is extensively watched. The DJIA is made up of 30 different equities. One Dow Future contract is worth ten times as much as the DJIA. The price of one Dow Future is $120,000 if the DJIA is trading at 12,000 points. The value of a Dow Future will increase by $10 if the DJIA climbs by one point. When the DJIA rises, a futures buyer gets money.
What is the purpose of the futures market?
Futures are significant tools for hedging and managing various types of risk. Foreign-trade companies utilize futures to manage foreign exchange risk, interest rate risk (by locking in a rate in expectation of a rate drop if they have a large investment to make), and price risk (by locking in prices of commodities such as oil, crops, and metals that act as inputs). Futures and derivatives help to improve the efficiency of the underlying market by lowering the unanticipated costs of buying an item outright. Going long in S&P 500 futures, for example, is far cheaper and more efficient than buying every company in the index.
What are futures on US stocks?
Futures are a sort of derivative contract in which the buyer and seller agree to buy or sell a specified commodity asset or security at a predetermined price at a future date. Futures contracts, or simply “futures,” are traded on futures exchanges such as the CME Group and require a futures-approved brokerage account.
A futures contract, like an options contract, involves both a buyer and a seller. When a futures contract expires, the buyer is bound to acquire and receive the underlying asset, and the seller of the futures contract is obligated to provide and deliver the underlying item, unlike options, which can become worthless upon expiration.
Why are stocks predicted by futures?
Futures provide a higher level of liquidity after-hours than stocks traded on ECNs, in addition to providing market access almost 24 hours a day. Because of the increased liquidity, tighter spreads are possible, which is important because the larger the spread, the more a transaction must move in your favor just to break even.