Futures – Trading with the Future

What are these mysteriously sounding futures? How do they differ from other instruments and how are they traded? The following text offers basic terminology and examples of various types of futures.

Futures are financial contracts in which two parties commit to exchanging a previously established amount of financial assets (for example foreign currency) or commodities (for example crude oil) in a predefined future moment at a predefined price. Futures are also characteristic with their daily calculation of profits and losses.

When we buy futures, we agree to the purchase of something that may not yet be produced or that the seller may not yet own, at a predetermined price (this position is called ‘long’). On the other hand, by selling futures we commit to selling a certain commodity or financial instrument at a predetermined price (the ‘short’ position). 

However, even in trading commodities futures, actual settlement of the contract may not occur. For example, futures for gold and copper traded in Singapore are settled exclusively financially (cash settlement). On the other hand, government bonds or gas are among those contracts in which physical delivery is still expected. 

But even here, the actual physical settlement represents only a fraction of cases. Usually traders conclude their positions by a reverse operation prior to the date upon which they are obliged to deliver the commodity (for example, if they bought futures, then they sell them prior to the expiration date of the contract). In case of contracts where physical settlement doesn’t take place, yet we would like to own the base asset, that’s solved in the spot (current) market where the required asset can be purchased (see examples below). The smallest amount of the base asset for which futures are traded is called a ‘lot’ – for example, in case of gold it’s equal to one hundred Troy ounces. If we want to buy or sell contracts for larger amounts, we must buy a corresponding number of lots (1,000 Troy ounces = 10 lots). A lot is indivisible and there is no such thing as futures for 150 Troy ounces. 

Futures in Daily Life

Futures are similar to another instrument called a ‘forward.’ The difference lies only in that futures are traded at organized markets (exchanges), while forwards trade at OTC (over-the-counter) markets.

Similarly to forwards, we can to a certain degree liken futures to a contract with a provider of internet connection (specifically that would be a series of futures one after another). We will agree that the given provider will provide us with connection of a certain quality for a previously established price and a specific amount of time, for example one year. This way we make sure that the product (internet) will be supplied throughout the year for the agreed price. If for some reason internet connections suddenly become more expensive, it will not affect us for the duration of the contract. On the other hand, the provider of the connection is certain we will be paying for a period of one year. They can both depend on the sure income and perhaps decrease costs in order to increase profits.  

One Example for All

Let’s assume we are in the role of a goldsmith and that in three months (the end of March) we will need to purchase a substantial supply of gold. We are concerned that the price of gold may go up or that there won’t be sufficient gold on the market. Perhaps we won’t be able to buy and fail to fulfill our obligations and deliver our already contracted goods. A solution is a futures contract for gold. 

We know we will have to buy gold. We therefore buy a corresponding contract on the market (this puts us in the ‘long’ position). Trading at the exchanges is anonymous, so we don’t even have to know who sold us the contract. It could, for example, be a gold producer who is trying to ensure a future sales price (he is in the ‘short’ position – promising to sell gold at the given price). 

Let’s say that we purchased a contract of a hundred Troy ounces, 1,000 USD each. The overall value of our contract is 100,000 USD. At this point we have not yet paid anything. Our only requirement is to deposit what is called a ‘margin’ with the exchange. The margin is established as a percentage of the value of the contract (see more about margins below).

The next notable aspect is the fact that we needn’t worry much about how much gold costs right now. We are only interested in the fact that we will be able to buy it in three months (but of course the prices are connected).

A specific characteristic of futures is that profits and losses from a contract are calculated each day. Therefore, if immediately (the next day after purchase) the contract price of an ounce increases by 10 USD to 1,010 USD, we will acquire a profit of 1,000 USD (as we have a hundred ounces). Again, this is not the price of gold on the given day but the price of gold delivered at the end of March (the contract date). This money is added to our exchange account. Should, on the other hand, the price drop, the money is subtracted. This calculation takes place on every trading day.

Why that is important becomes apparent at the end of March, when the account is settled. This is the date upon which the current price comes in, which in the meantime has reached 1,200 USD per ounce. Gold is on the market at 1,200 USD per ounce, but in theory we bought it at 1,000 USD per ounce. If we didn’t actually want to use it ourselves, we could immediately sell it. Our profit would then be 200 USD per ounce, which for our hundred ounces would earn us 20,000 USD.

In practice, the process is not very different. If the price per ounce reached 1,200 USD, we would receive our required one hundred ounces from the opposite contractual party (this takes place through certified exchange storages) for 120,000 USD. But we have an additional 20,000 USD in our account to cover this increased price of gold (resulting in 1,000 USD per ounce). If we didn’t want to process or own the gold, we could instantly sell it for 120.000 USD. The following table shows a situation in which the price remained the same (Scenario 2) and a situation where it would drop (Scenario 3). 

The Difference between Futures and Forwards

• A forward is similar to futures in that it also covers the purchase/sale of commodity or a financial instrument in the future for a previously established price.
• However, profits and losses are not counted every day in forwards, but only at the time of the expiration of the contract. The result would be the same, but the daily accounting of profits and losses disappears. The purpose of daily accounting of profits and losses is that if we ‘scored’ and money is accumulating in our exchange account (as it was in our example), we may withdraw a portion of it and use it for other purposes.
• Another advantage of futures as opposed to forwards is that they are traded at exchanges. Thus it is much easier to find a suitable counterparty. Additionally, unlike in OTC markets, every exchange participant receives the same price (the risk of adverse selection is considerably lowered). 
• Futures also don’t bear any credit risk in case your counterparty fails to pay or deliver the required commodity or financial asset. Unlike in forwards, the exchange bears the credit risk for futures contracts.
• Because the volume of traded futures is enormous, there is no problem in closing one’s position anytime by executing the opposite operation on the market (to sell a purchased contract or buy a different one if we sold it before). Let assume in our example that after a month we find we will not need a hundred ounces, but only fifty. We don’t want to expose ourselves to the risk of the price dropping and us losing money, but we want to use the money tied up in the exchange account (deposited as margin). The market at this point expects that the price at the end of March will be 1,100 USD per ounce. We may sell fifty ounces of gold and earn a profit of 5,000 USD (100 USD per ounce).

What Is Margin?

At the futures markets, margin is a monetary deposit that is held in the exchange account upon opening the market position (a purchase or sale of a contract). This amount then covers the possible daily exposure to losses from the contract. To the contrary, profits are added to the account. Upon opening the position, an initial margin must be paid. When the contract is closed, the trader receives this margin back, plus or minus any profits or losses.

The initial margin is usually stipulated as 5–10% of the value of the contract. However, the exchange may vary this percentage according to the situation – in times of higher volatility, margins increase. Each contract also stipulates a maintenance margin – the minimum amount that must remain in the account. Should the funds at the exchange reach the level of the minimal margin, the exchange asks the trader to top up his funds to the level of the initial margin (margin call). In case the initial margin is 1,000 USD, the maintenance margin is 500 USD and our funds at the account drop to 400 USD, we must deposit an additional 600 USD.

The Use of Futures

Futures may be used in several of the following ways:

• A Security Instrument – the futures markets provide traders with a great opportunity to hedge against future price fluctuations. This lowers the risk that the price will develop unfavorably. On the other hand, they lose their option to make money when a favorable change of prices occurs.
• An Investment into a Base Asset – futures can be also used for investments into base assets, such as shares combined into a stock index upon which futures contracts can be traded. There are two advantages to this investment – first, it can be done even if we don’t have sufficient funds – for example we might not have sufficient funds to purchase all shares in the index in the proper ratio. Another advantage is that the futures can be used as leverage, because only the margin must be paid at the time of opening the position. We can multiply our profits using this leverage effect (but possibly also multiply our losses as well).
• Speculation – Similar to other financial instruments, futures can be used for pure speculation. Just as in the case of an investment into a base asset, we can use the leverage effect here as well. Additionally, thanks to futures contracts it is simpler to speculate on the drop of price (short).

Types of Futures Contracts

Futures contracts exist for:

• commodities – gold, silver, crude oil, grain, natural gas, coffee, cocoa, etc. – see examples above
• shares – individually or as entire stock indexes – see example in this text
• currency pairs (the Forex market) – see example in this text
• vyields from government bonds – see example in this text
• interest rates – for example the London Interbank Offered Rate (LIBOR) – see example in this text
• weather – see example in this text
• volatility (fluctuations of prices in the markets) – for example, options for the stock index S&P 500 – see example in this text

1. Definition of Algorithmic Trading

Also included the expressions automated trading, algo trading, black-box trading and robo trading.

There is no unified definition of algorithmic trading (AT). Some definitions are broad and unspecific: trading using algorithms, trading programs. Others specify AT as opposed to high-frequency trading (HTF), emphasizing that algorithms are only entrusted with the execution of a business decision – however the decision of its acceptance is still up to people. This definition then entirely excludes HFT (that most of professionals consider a part of AT). We therefore consider the best definition of algorithmic trading to be one that stipulates AT are all operations at exchanges and similar markets (such as OTC markets), in which a previously programmed algorithm takes care of an algorithmic execution of a business instruction (purchase, sale, exchange listing). A sub-section of thus defined AT are business models in which a computer (specifically speaking, an algorithm) itself decides whether a business instruction will be sent to the exchange at all, based on previously entered settings (algorithmic decision-making) – this is where HFT belongs.

2. Definition of High-Frequency Trading

Also includes the expressions high-rev trading or high-speed trading.

There is no unified definition of high-frequency trading (HFT). Most professional literature agrees that HFT is a sub-category of algorithmic trading, meaning trading at financial markets using algorithms/computers (see the definition here). In the case of HFT this is algorithmic decision-making, where the algorithm itself, based on previously programmed instructions and in accordance with a targeted strategy, determines whether a trade will take place. The resulting position of the trader is not known in advance.

A different situation is where the algorithm solely determines, how, when and where the instruction will be performed (algorithmic execution). Here, the resulting position is known in advance, determined by a human (for example we instruct the algorithm to purchase 1,000 shares of Microsoft and will take ownership of this company’s 1,000 shares, but for extreme events such as a market crash).

However, we can’t claim algorithms in HFT do the trading on their own. They are merely a tool for traders, who constantly monitor them and are thus able to more quickly respond to changes in the market than is possible using the human brain. HFT traders seek certain strategies that, in today’s markets, require very fast and very frequent responses.

Most professional literature agrees on several HFT characteristics. These are:

• High frequency of orders or instructions (messages) sent to the exchange – hence the high frequency of trades.
• Proprietary trading – HFT companies usually do not lease their algorithms.
• Profit from the purchase and sale as a mediator – an opposite to the long-term speculative possession of assets.
• Very short time periods for the possession of assets.
• Necessity of fast reaction to events in the market (low latency) – hence the placing of computer technology directly within the exchanges (co-location).
• Focus on highly liquid (frequently traded) assets. 

High frequency of trades, particularly of instructions being sent to the market, may be considered as the most typical characteristic of HFT. That also explains why, to some degree, machines perform the trades on behalf of people.

Other characteristics are either secondary or derived. The rate with which these trades are executed is not sufficient to define their main characteristic, because other very fast algorithms that are not part of HFT also exist.

A question remains, whether we can determine a clear delineation of trades frequency by which we could identify a trader as a high-frequency trader and whether such an attempt would have any benefit other than the purely academic. It makes more sense to discuss the specific trading strategies targeted by high-frequency traders.

The study Definition, Benefits and Risks of High-Frequency Trading (Jakub Kučera, ACTA OECONOMICA PRAGENSIA 5/2013, only in Czech) discusses reasons why the speed of instructions sent to an exchange is the most accurate characteristic of HFT.