With all the news about Bitcoin becoming front page, many of you have likely heard that two large exchanges, CBOE and CME, decided to open futures trading for Bitcoin. If you are like the vast majority of people then you likely do not know what futures are. Luckily that is about to change.
Futures fall into an category of securities (investments) known as “derivatives.” To put it simply derivatives are investment vehicles with prices or values that are derived from some sort of underlying asset. Whether you make money or lose money on a derivative will be based on the price movement of the underlying asset, even though you never actually own the underlying asset during a futures contract.
Derivatives encompass things like futures, options, swaps and other vehicles, but for now we will focus in on just futures.
What Are Futures?
Futures, or futures contracts, are contracts to buy or sell something at a specific price on a future date. Now the name makes sense!
While some derivatives lend themselves more to speculative investment, futures are a type of derivative frequently used more for hedging purposes. Many large companies use futures to reduce risks such as exchange rate risk (the dollar becoming less valuable) or commodity price risk.
Not A Virgin Airlines is currently very profitable due to low oil prices. The CEO is willing to give up the chance for more profitability from lower oil prices in order to avoid the risk of squeezed margins from higher prices. This choice can give shareholders comfort that Not A Virgin Airlines’ profitability will not be compromised by a sudden spike in oil prices.
In order to accomplish this, the financial planning team at Not A Virgin Airlines purchases futures contracts for oil at $50/barrel. By purchasing these contracts, the company is now guaranteed the ability to buy the specified number of barrels of oil at $50 a barrel on the date specified in the futures contract. Now the CEO does not have to worry about any fluctuations in the price of oil because the $50 price has been effectively locked in.
The counter-party, in this case whoever is willing to sell Not A Virgin Airlines oil, sells the futures contract and likewise gets the security of knowing they are guaranteed future revenues of $50 a barrel for the specified amount of barrels in the contract.
Futures Contract Expiration
When the expiration date on a futures contract is reached the contract expires and the two parties must settle on the promised transaction. Settlement comes in two varieties:
Physical– settlement occurs with the delivery of actual goods, be that oil, gold, or cattle. The seller of the contract is paid the contract price, and the buyer at this point in time will receive the underlying asset.
Cash– settlement occurs in cash. Let’s go back to the Not A Virgin Airlines example. Let’s say that the futures contract they purchased is cash settled and was for 1 million barrels of oil. If the price of oil is $55/barrel on the expiry date of the contract then Not A Virgin Airlines would receive payment equal to the difference of the current price and the contract price multiplied by the number of units agreed upon in the contract ($55-$50 x 1,000,000). This means that Not A Virgin Airlines would receive a cash payment of $5,000,000 in this example.
Futures Contract Risks
While many companies use futures as a way to reduce risks, many people trade futures as a way of speculating on future prices. It is also possible to lose more money than you have in your account when trading futures.
Since you aren’t purchasing the actual underlying asset when you buy a futures contract you are not required to pay what that asset costs. Instead you must essentially put up collateral for the contract known as “margin.” I will cover this concept more in a later post.
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