Futures position

What Is a Futures Position?

A futures position refers to the commitment made by a market participant to buy or sell a specific quantity of an underlying asset at a predetermined price on a future expiration date. This commitment is established through a futures contract, which is a standardized agreement traded on an exchange within the broader category of derivative financial instruments. When an investor takes a futures position, they are essentially expressing a view on the future price direction of the underlying asset, whether it be a commodities, a financial index, or a currency. The two primary types of futures positions are a long position, where one agrees to buy the asset, and a short position, where one agrees to sell the asset.

History and Origin

The concept of agreeing to buy or sell goods at a future date for a predetermined price dates back centuries, with early forms of forward contracts appearing in ancient civilizations. However, the modern, standardized futures market has its roots in agricultural trade. In the United States, the Chicago Board of Trade (CBOT), established in 1848, was pivotal in formalizing these agreements. Initially, it served as a cash market for grain, but the need for price certainty led to the development of "to-arrive" contracts. These early forward agreements evolved into standardized futures contracts, with the CBOT listing the first such contracts in 1864. This standardization made futures positions more liquid and tradable.

The Chicago Board of Trade, founded by Chicago merchants, was created to address the risks and inefficiencies inherent in commodity trading, such as credit risk and the difficulty of finding buyers and sellers. The CBOT quickly became a major center for futures trading, particularly for agricultural products like wheat and corn.⁷ By the 1970s, the futures market expanded significantly beyond agricultural products to include financial futures, such as currency futures and interest rate futures, greatly broadening the scope of assets on which a futures position could be taken.⁶, The establishment of the Commodity Futures Trading Commission (CFTC) in 1974 marked a significant step in regulating these expanding markets.⁵,⁴

Key Takeaways

• A futures position represents a binding commitment to buy or sell an underlying asset at a future date at a set price.
• Taking a long position in futures implies an expectation of rising prices, while a short position anticipates falling prices.
• Futures positions require an initial margin deposit and are subject to daily mark-to-market adjustments.
• Futures contracts are primarily used for hedging against price risk or for speculation on price movements.
• Understanding a futures position involves knowing the contract's underlying asset, size, expiration date, and the party's intent (long or short).

Formula and Calculation

While there isn't a single "formula" for a futures position itself, its value and the profit/loss associated with it are calculated based on the contract's notional value and price changes.

The notional value of a futures contract is determined by:

Profit or Loss (P/L) for a futures position is calculated as:

or

These calculations demonstrate how the value of a futures position changes with market movements. Participants are required to maintain a margin account with their broker, which is adjusted daily to reflect these profits or losses through the mark-to-market process.

Interpreting the Futures Position

Interpreting a futures position involves understanding the market participant's objective and risk exposure. A participant holding a long position is exposed to the risk of the underlying asset's price falling, as they are obligated to buy at a higher agreed-upon price. Conversely, a participant holding a short position faces the risk of the asset's price rising, as they must sell at a lower agreed-upon price. The magnitude of potential profit or loss is directly proportional to the change in the futures price and the number of contracts held.

The transparency of futures markets, with prices and trading volumes publicly available, allows for effective price discovery. This means that the futures price at any given moment reflects the collective expectations of market participants regarding the future value of the underlying asset. This characteristic makes futures positions valuable tools for gaining insight into market sentiment.

Hypothetical Example

Consider an airline company, AeroFly, that is concerned about rising jet fuel prices in three months. To mitigate this risk, AeroFly decides to take a long position in crude oil futures contracts, as crude oil is the primary input for jet fuel.

1. Current Situation: Crude oil futures for delivery in three months are trading at $70 per barrel. Each contract represents 1,000 barrels.
2. AeroFly's Action: AeroFly buys 10 crude oil futures contracts at $70/barrel. This establishes their futures position. Their total exposure is $70 x 1,000 barrels/contract x 10 contracts = $700,000.
3. Scenario 1: Fuel Prices Rise. In three months, the price of crude oil futures rises to $75 per barrel.
   • P/L Calculation: ($75 - $70) x 1,000 barrels/contract x 10 contracts = $50,000 profit from their futures position.
   • Outcome: Although AeroFly will likely pay more for physical jet fuel in the spot market, the $50,000 profit from their futures position helps offset the increased cost, effectively hedging their fuel expenses.
4. Scenario 2: Fuel Prices Fall. In three months, the price of crude oil futures falls to $65 per barrel.
   • P/L Calculation: ($65 - $70) x 1,000 barrels/contract x 10 contracts = -$50,000 loss from their futures position.
   • Outcome: AeroFly will pay less for physical jet fuel, but the loss from their futures position partially offsets these savings. This demonstrates the cost of hedging when the market moves favorably for the underlying need.

This example illustrates how a futures position can be used for risk management, providing a degree of price predictability for future expenses.

Practical Applications

Futures positions are integral to modern financial markets, serving a variety of practical applications for different participants.

• Hedging: Producers and consumers use futures to lock in prices for future transactions, protecting themselves from adverse price movements. For example, a farmer might take a short position in corn futures to ensure a minimum selling price for their upcoming harvest, while a food manufacturer might take a long position to secure input costs.
• Speculation: Traders who believe they can accurately predict future price movements use futures positions to profit from these predictions. They may take a long position expecting prices to rise or a short position expecting them to fall. The inherent leverage in futures contracts amplifies both potential gains and losses for speculators.
• Price Discovery: Futures markets concentrate diverse information and opinions into observable prices. The continuous trading of futures contracts provides a consensus view of an asset's future value, which can guide production, consumption, and investment decisions. The economic functions of derivatives markets, including futures, extend to providing valuable information for price discovery.³ This helps in efficient resource allocation.²
• Portfolio Diversification: Institutional investors may use futures positions to gain exposure to various asset classes (e.g., commodities, currencies) without directly holding the physical assets, contributing to overall portfolio diversification.
• Arbitrage: Discrepancies between futures prices and spot prices, or between different futures contracts, create opportunities for arbitrageurs to profit by simultaneously taking opposing futures positions in different markets.

Limitations and Criticisms

While futures positions offer significant benefits, they also come with inherent limitations and criticisms:

• Leverage and Risk: Futures contracts typically involve substantial leverage, meaning a small price movement can lead to a large percentage gain or loss on the initial margin deposit. This amplification of risk can lead to rapid and significant losses for traders, particularly those engaged in speculation without adequate capital or risk management.
• Mark-to-Market Requirements: Futures positions are revalued daily, and profits or losses are credited or debited to the trader's margin account. If a position moves against the trader, they may face a margin call, requiring them to deposit additional funds to maintain their position or face forced liquidation.
• Complexity: Understanding the nuances of different futures contracts, their underlying assets, delivery specifications (or cash settlement), and expiration cycles can be complex, especially for novice investors.
• Market Volatility: Futures markets can be highly volatile, particularly for certain commodities or financial instruments influenced by geopolitical events, economic data releases, or unexpected supply/demand shocks. Such volatility can lead to rapid erosion of a futures position's value.
• Liquidity Risk: While major futures contracts are highly liquid, some less actively traded contracts may present challenges in exiting a futures position quickly without significantly impacting the price.

The history of futures markets includes instances where market manipulation and excessive speculation led to calls for regulation, highlighting the need for robust oversight mechanisms, such as those provided by the CFTC.¹

Futures Position vs. Options Position

A futures position and an options position are both types of derivative financial instruments used for hedging and speculation, but they differ significantly in their obligations and risk profiles.

The key distinction lies in the obligation inherent in a futures position versus the right in an options position. Someone holding a futures position must fulfill the contract, either by offsetting it before expiration or by taking/making delivery of the underlying asset. In contrast, an options holder can simply let the option expire unexercised, limiting their loss to the premium paid.

FAQs

What does it mean to "close" a futures position?

Closing a futures position means entering into an opposite transaction to offset the original contract. For example, if you initially took a long position by buying a futures contract, you would close it by selling an identical futures contract. This negates your obligation to buy or sell the underlying asset and locks in any profit or loss.

How is a futures position different from a stock position?

A futures position involves a contract to buy or sell an asset at a future date, whereas a stock position means you own shares of a company today. With a stock, you have ownership rights; with a futures position, you have a contractual obligation. Futures inherently use leverage and have a defined expiration date, unlike holding common stock.

Can a futures position result in physical delivery?

Yes, depending on the terms of the specific futures contract, a futures position can result in the physical delivery of the underlying commodity or financial instrument. However, many futures contracts, especially those based on indexes or certain financial instruments, are cash-settled, meaning profits and losses are exchanged in cash at expiration without physical delivery. The terms are standardized by the clearinghouse.

What is a "net" futures position?

A net futures position refers to the overall exposure a trader or entity has to a particular underlying asset or market, considering all their open long positions and short positions in futures contracts. For instance, if a trader has 10 long contracts and 3 short contracts in the same futures market, their net futures position would be 7 long contracts.