Futures and options are derivative contracts that set a specific price for the sale of an asset at a specific time in the future.
Traditionally, futures and options allow the owner of the contract to buy something, say barrels of oil, at a specific price on a specific date. They bring an element of predictability for buyers of commodities, for example. Airlines want to make sure they can lock in the price of future oil at a price they can afford.
Futures and options markets were created to allow these contracts to change hands. Most futures traders today do not intend to actually take delivery of an asset – outside the commodities markets, futures can be traded based on the prices of stock market indexes, currencies or blue chip stocks.
Futures and Options contracts have an expiry date
Futures and options contracts will have an expiry date. This is when the contract ends. For exchange-traded futures, which is where the biggest volume exists, contracts are very standardised, and will tend to expire at the end of a particular month. This allows traders and investors to take a view on the direction of prices over a longer period of time by buying/selling longer dated contracts.
Commodities markets function as futures and options markets: while spot prices are often quoted (the price of the commodity today). In reality, traders are dealing in contracts that will be settled in the future. The contract closest to the actual price is the next contract to expire. Big commodity markets like crude oil, gold, natural gas or soya beans all function on the basis of futures.
A wide range of markets
There is an ever-increasing range of futures contracts to choose from. Index futures are becoming increasingly popular with traders. These use high levels of leverage to allow traders to exploit movements in an index, including out of hours. While stock markets may close to allow the brokers to go home and sleep, futures markets will stay open, letting you trade even during the middle of the night.
Other futures and options markets cover government bonds, large stocks and currencies. Be aware, however, that futures are riskier than trading stocks and bonds. Some futures contracts require high levels of leverage, which means that sudden changes in price in the underlying market could cost you a lot of money. Also, futures contracts bring with them the obligation to buy assets when they expire – you may actually want to do this, as if the asset you buy using your contract is more expensive in the underlying market, you can make a tidy profit. However, it is bad news to hold a contract to maturity when it is more expensive than the underlying market.
Futures and Options as a hedge
Futures and Options markets can also be used to protect yourself against changes to your existing portfolios of stocks. Index futures, for example, can make you money if you are losing money in the physical market, thereby helping to reduce your losses.
While many futures contracts are expensive, with high minimum contract sizes, some exchanges have been introducing cheaper contracts to attract private traders. One of the most popular is the S&P e-mini futures, which can change hands for a fraction of the cost of conventional S&P 500 futures, and allow US and foreign traders to trade an exchange-based contract on the S&P 500.
The e-mini futures concept has led to a broad market of cheaper index futures, including Nikkei 225, and Russell 2000, and e-micro futures on major currency pairs like GBP/USD or USD/JPY.
Some contracts will be quoted at multiples of the current index value – e.g. Dow Jones EuroStoxx 50 at €10 x index value. Others will be quoted as specific value lots – e.g. €36,000 for French CAC 40 futures.
The market for futures is heavily exchange-traded now, making pricing more efficient and transparent.