What it means
The futures market is made up of exchanges, clearing houses, brokers and the participants who trade. Exchanges list standard contracts on assets such as energy, metals, farm products, interest rates, currencies and stock indices.
They set the rules for contract size, quality, delivery months and trading hours. The clearing house is the core of the system.
It becomes the buyer to every seller and the seller to every buyer, which removes the risk that one trader fails to pay another. In return, it requires margin deposits and settles gains and losses each day, so debts cannot build up unnoticed.
Prices in the futures market also act as information for the wider economy. A farmer, a manufacturer or an analyst can look at the price of a contract for delivery in six months and get a view of what the market expects.
This process is called price discovery, and it often moves ahead of the price for immediate delivery. Participants fall into two broad groups.
Hedgers, such as airlines, food producers and miners, use the market to protect against unwanted price moves, while speculators accept those risks for a potential reward and keep trading active. Large volumes make it easy to enter and exit positions, which is valuable to both groups, because a hedger needs to be able to close a position as soon as the underlying risk has passed.
The nuance is that leverage works in both directions. A small margin deposit controls a much larger contract value, so even a modest price move can cause a large gain or loss relative to the deposit.
Rules on margin levels, position limits and reporting exist to keep the market orderly.
In practice
Real-world examples.
Example
A cereal manufacturer uses the futures market to fix the price of corn for the next nine months. Its treasurer sells the position before expiry as the grain is bought from local suppliers. The company gets price certainty without having to store the corn.
Example
A mining company sells copper futures to protect the revenue from its next quarter of production. If the copper price falls, the gain on the futures makes up part of the lower sales revenue. The bank financing the mine is more comfortable lending against a steadier cash flow.
Example
A private investor opens a small position in a stock index future to express a view that the market will rise. She keeps a cash buffer to meet margin calls and sets a limit on how much she is willing to lose. She closes the position when it reaches her target.
Formula
Calculation
Leverage = contract value / margin deposit
Contract value = futures price x contract size
Suppose a gold futures contract covers 100 ounces and the futures price is $2,000 per ounce. Contract value = 2,000 x 100 = $200,000. If the margin required is $10,000, leverage = 200,000 / 10,000 = 20 times. A 1% rise in the gold price changes the contract value by 200,000 x 0.01 = $2,000, which is 2,000 / 10,000 = 20% of the margin deposit.Case study
Seen in the real world.
Meridian Foods is an illustrative, fictional manufacturer of breakfast cereals that had never used futures. Its finance team watched the market for a quarter, comparing futures prices for corn and sugar with what the company actually paid.
They noticed that the futures prices tended to give a useful signal about where prices were heading, and that hedging half of their purchases would have narrowed the swings in their monthly costs. The board approved a small pilot with strict limits on position sizes and cash committed to margin.
In the illustrative result, the pilot reduced cost variance and gave the sales team more confidence in setting list prices. The finance director concluded that the market was less about guessing prices than about buying certainty, and the board agreed to extend the policy to sugar the following year.
Watch out
Common mistakes.
- Believing the futures market is only for speculators, when much of its activity comes from businesses managing real price risks.
- Forgetting that daily settlement means cash moves every day, not only when the contract ends.
- Treating a futures price as a guaranteed forecast, when it is simply the market's current agreed price and can change quickly.
Questions
People also ask.
Who guarantees the trades?
The clearing house does, by acting as the counterparty to every buyer and seller and by collecting margin deposits, which are topped up or released each day as prices move.
Can individuals trade in the futures market?
Yes, through a licensed broker, although the leverage means the risks are high, so many people limit their exposure.
How is the futures market different from the stock market?
The stock market trades ownership in companies, while the futures market trades contracts for future delivery of an asset, with expiry dates and daily settlement.
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