Futures and derivatives markets
A future is a binding agreement to buy or sell at a later date. Unlike options, both sides carry an obligation.
A farmer agrees in spring to sell his wheat in autumn at a fixed price. Both sides know where they stand. That's the original idea behind futures markets.
The difference from an option matters: with an option, the buyer has a right. With a future, both sides have an obligation. There's no letting it expire.
Futures are standardized and trade on exchanges. You post collateral, and gains or losses get settled daily. If the collateral no longer covers it, you have to add more.
For retail investors, they're usually unsuited, since contract sizes are large and daily settlement means an ongoing margin-call obligation. Anyone using them anyway should know the contract size precisely, not just the collateral posted.
Futures are standardized forward contracts with a central counterparty that assumes default risk and secures it through margin. Daily gain-and-loss settlement distinguishes them from forwards, where settlement only happens at maturity. That daily settlement is what creates the ongoing liquidity requirement.
The theoretical price follows from cost-of-carry parity: F = S · e^((r + u − y)T), with r financing costs, u storage costs, and y a convenience yield. For non-storable underlyings, the storage-cost term drops out. Deviations from this relationship get largely arbitraged away.
The convenience yield explains backwardation in commodities with scarce physical availability. For strategies that continually roll futures contracts, the resulting roll yield is the decisive return component alongside the spot-price change, already covered in the commodities lesson back in Stage 0.
Summary
- With futures, both sides carry an obligation, not a right.
- Daily settlement creates an ongoing margin-call obligation.
- What matters is the contract size, not the collateral posted.
Did you get it?
What distinguishes a future from an option?
With an option, the buyer has a right; with a future, both sides carry an obligation.
What does daily gain-and-loss settlement mean?
Losses get settled daily, requiring continual top-ups of collateral.
What does your risk in a future depend on?
The contract size, not the collateral posted.
Related
- CommoditiesStage 0
- CFDs, and why regulators warn about themStage 2
- Options: calls and putsStage 4