Market Mechanics: How Futures Market Works

Futures trading is one of the core tenets of dealing in derivatives, and for most traders it pays to be familiar with the nature of the instrument and how the markets for them work. Futures contracts are traded exclusively through futures exchanges, which operate in much the same way as stock markets and automate transactions between buyers and sellers. But the market for futures has its own dynamic, and responds in its own way to different external prompts as a result of its numerous distinctive features. Here’s a brief run down of some of the key characteristics of the futures market you should be aware of, and should take care to factor in to your thinking about trading futures contracts.

Cash Settlement vs. Physical Settlement

Futures contracts are settled on either a physical delivery basis, where the bearer takes stock of the relevant underlying asset upon the expiry date, or on a cash only basis where the trader automatically and instantly sells his interest in the physical asset for money’s worth. Both of these options are commonly traded on futures exchanges, so it pays to make sure you are aware of exactly what you’re buying before you leap in feet first. After all, no one wants to have to deal with the headache and financial implications of managing a ton of steel!

Price Decay

Because futures contracts have a defined end date at which the underlying asset must be bought, the price of each contract will decay as you move closer towards the end date. Imagine for the sake of ease an underlying asset had a constant value of £100 over the duration of the lifespan of the futures contract, which ties the bearer in to buy said asset for £100. If the value of the futures contract starts off at £5, it will become increasingly worthless in time as it becomes more viable just to buy the asset at £100. Even if asset prices rise over time, the incremental correlative rise in futures price will slow down as the contract nears its expiry date.

Asset Price Movement

Asset price movements have a direct impact on the value of the underlying futures contract, so any forecasts as to whether a position might be profitable should be based directly on whether it is foreseen that the underlying asset will rise. The pricing of a futures contract factors in the value of the tie-in price – not in terms of the monetary equivalent of the tie-in price, but rather the value of the ability to acquire the underlying asset at the said price. This is naturally directly correlative to the price of the asset, because the value of being able to acquire anything at yesterday’s prices depends on its price today, tomorrow, next week – especially when prices are as sensitive to supply and demand as with exchange traded assets.

Margin

The concept of margin is another to bear in mind when it comes to trading in futures contracts. As a party to a futures contract, you will be required to cover a margin portion, which accounts for the risk of default and acts as a form of security deposit on the deal. Likewise, the issuer of the futures contract will also be required to pay down his margin in respect of honouring the position, which breeds a degree of security and confidence into the market. This also allows for buyers to leverage their positions, given that margin portions need only be in the region of 5-12%, depending on the exact requirements of your broker. This paves the way for significant gains to be realised on small transaction sizes – one of the core benefits of trading on the futures market.

Be Sociable, Share!