Futures positions

What Is Futures Positions?

Futures positions represent an investor's commitment to either buy or sell a specific quantity of an underlying asset at a predetermined price on a future date. These positions are a core component of derivatives markets, where financial instruments derive their value from an underlying asset. When an investor takes a long position in futures, they agree to purchase the asset, anticipating a price increase. Conversely, a short position involves agreeing to sell the asset, with the expectation that its price will decline. These commitments are standardized through futures contracts traded on organized exchanges.

History and Origin

The concept of agreeing to buy or sell a commodity at a future date dates back centuries, but the formalization of standardized futures contracts and centralized exchanges began in the mid-19th century in Chicago. The Chicago Board of Trade (CBOT), established in 1848, initially served as a cash market for grain. By 1865, the CBOT formalized "to-arrive" contracts into standardized futures contracts, creating the world's first futures exchange⁵. This innovation provided farmers and merchants with a mechanism to manage price risk. The Chicago Mercantile Exchange (CME), founded in 1898 as the Chicago Butter and Egg Board, further expanded the scope of futures trading. The CME later launched its first agricultural futures contracts on frozen pork bellies in 1961, and a pivotal shift occurred in 1972 with the introduction of financial futures contracts, including agreements on foreign currencies⁴. These developments laid the groundwork for modern futures markets, facilitating hedging and speculation across a wide range of assets. Today, the CME Group is a leading global operator of financial derivatives exchanges.

Key Takeaways

• Futures positions are commitments to buy (long) or sell (short) a specific asset at a future date for a predetermined price.
• They are standardized contracts traded on organized exchanges, unlike over-the-counter agreements.
• Market participants use futures positions for both hedging against price fluctuations and speculation on future price movements.
• Futures positions involve leverage, meaning a small capital outlay can control a large contract value, amplifying both potential gains and losses.
• All exchange-traded futures positions are guaranteed by a clearing house, which acts as the counterparty to every trade, mitigating counterparty risk.

Formula and Calculation

While there isn't a single "formula" for a futures position itself, the value of a futures contract, and thus the profit or loss from a futures position, is determined by the difference between the contract price and the eventual settlement price.

The daily profit or loss for a futures position is calculated as:

The total profit or loss upon closing or expiration of a futures position is:

Variables:

• Current Futures Price: The current market price of the futures contract.
• Previous Day's Settlement Price: The price at which the contract was marked to market the previous trading day.
• Closing/Settlement Price: The price at which the futures position is offset or the contract expires.
• Opening Price: The price at which the futures position was initially established.
• Contract Size: The standardized quantity of the underlying asset specified in one futures contract.
• Number of Contracts: The total number of futures contracts held in the position.

Futures contracts require traders to post an initial margin and are subject to daily "marking to market," where gains and losses are settled, requiring additional margin calls if losses deplete the account below the maintenance margin level.

Interpreting the Futures Position

Interpreting futures positions involves understanding the directional bias and the intent behind holding the position. A long position indicates an expectation of rising prices for the underlying asset. This could be due to anticipated supply shortages, increased demand, or other market catalysts. Conversely, a short position suggests a belief that prices will fall, perhaps due to oversupply, decreased demand, or negative economic outlooks.

Traders and investors evaluate futures positions by comparing the contract price to the current spot price of the underlying asset, as well as considering economic indicators, geopolitical events, and technical analysis. The duration of the position also matters; some positions are held for day trading, while others are longer-term strategies. The overall open interest and volume in a particular futures market can provide insights into market sentiment and liquidity, helping market participants interpret the significance of large futures positions.

Hypothetical Example

Consider a farmer, Sarah, who expects to harvest 5,000 bushels of corn in three months. The current spot price of corn is $4.50 per bushel. Sarah is concerned that the price of corn might drop by harvest time, reducing her income. To manage this market risk, she decides to take a short position in corn futures contracts.

One corn futures contract typically represents 5,000 bushels. Sarah sells one corn futures contract expiring in three months at a price of $4.40 per bushel.

Scenario 1: Price of corn falls
At harvest time, the spot price of corn has fallen to $4.20 per bushel. Sarah sells her physical corn in the cash market for $4.20 per bushel, realizing a lower price for her crop. However, her futures position has gained value. The futures contract she sold at $4.40 can now be bought back (offset) at $4.20.

• Loss on physical corn: ($4.50 - $4.20) x 5,000 = $1,500
• Gain on futures position: ($4.40 - $4.20) x 5,000 = $1,000

In this scenario, the futures position helped offset a portion of her loss from the declining corn price, demonstrating effective hedging.

Scenario 2: Price of corn rises
At harvest time, the spot price of corn has risen to $4.70 per bushel. Sarah sells her physical corn in the cash market for $4.70 per bushel, realizing a higher price for her crop. Her futures position, however, has lost value. The futures contract she sold at $4.40 now needs to be bought back at $4.70.

• Gain on physical corn: ($4.70 - $4.50) x 5,000 = $1,000
• Loss on futures position: ($4.70 - $4.40) x 5,000 = $1,500

In this case, while the futures position resulted in a loss, it was more than compensated by the gain in the physical commodity, and Sarah successfully locked in a price near her initial expectation.

Practical Applications

Futures positions are integral to various financial activities, extending beyond simple directional bets on asset prices. They are widely used for:

• Risk Management (Hedging): Corporations, farmers, and financial institutions utilize futures positions to mitigate exposure to adverse price movements in commodities, currencies, interest rates, or stock indices. For instance, an airline might take a long position in crude oil futures to lock in fuel costs, protecting against rising prices.
• Price Discovery: The active trading of futures contracts on regulated exchanges like the CME Group helps in the formation of transparent and efficient prices for the underlying asset, reflecting collective market expectations.
• Speculation: Traders who seek to profit from anticipated price movements take futures positions. Given the inherent leverage in futures, even small price changes can lead to significant gains or losses.
• Arbitrage: Sophisticated traders may identify and profit from temporary price discrepancies between futures contracts and their underlying assets, or between futures contracts with different expiration dates.
• Portfolio Diversification: Adding futures to a portfolio can provide exposure to various asset classes or strategies, potentially enhancing returns or reducing overall portfolio volatility.
• Regulatory Oversight: In the United States, the Commodity Futures Trading Commission (CFTC) is the primary federal agency responsible for regulating the U.S. derivatives markets, including futures. The CFTC's mission is to promote market integrity, resilience, and vibrancy³.

Limitations and Criticisms

While futures positions offer significant advantages, they also carry considerable risks and are subject to scrutiny.

• Leverage Risk: Futures contracts involve substantial leverage, meaning a small initial margin deposit controls a much larger contract value. While this can magnify gains, it also amplifies losses, potentially exceeding the initial investment. This characteristic is a primary source of market risk in derivatives trading².
• Liquidity Risk: Although exchange-traded futures are generally liquid, certain less active contracts or extreme market conditions can lead to periods where it is difficult to exit a futures position quickly without significantly impacting the price.
• Volatility: The prices of underlying assets, and consequently futures positions, can be highly volatile. Sudden and sharp price swings can result in rapid and substantial losses, especially if positions are highly leveraged. Regulatory bodies, such as the SEC and CFTC, have issued warnings about the highly speculative nature and volatility of certain futures markets, such as Bitcoin futures¹.
• Complexities: Understanding the intricacies of futures markets, including contract specifications, expiration dates, and roll-over strategies, can be complex for inexperienced investors. Misunderstanding these aspects can lead to unintended consequences or losses. The National Institute of Securities Markets (NISM) on Derivatives Risks highlights various risks associated with derivatives, including market, credit, and operational risks.
• Regulatory Scrutiny: Due to the potential for high risk and large market impact, futures markets are subject to strict regulation. However, incidents of manipulation or abusive trading practices can still occur.

Futures Positions vs. Options Contracts

Futures positions and options contracts are both types of derivatives that allow investors to speculate on or hedge against the future price movements of an underlying asset. However, a fundamental difference lies in the obligation they impose.

A futures position commits the holder to fulfill the contract at expiration or offset it beforehand, whereas an options contract grants the holder the choice to exercise their right or let the option expire worthless. This distinction in obligation profoundly impacts the risk-reward profiles of each instrument.

FAQs

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

To hold a futures position means to have an open commitment to either buy or sell a specific quantity of an underlying asset at a future date at a predetermined price. If you anticipate prices to rise, you would hold a long position. If you expect prices to fall, you would hold a short position.

How is profit or loss calculated on a futures position?

Profit or loss on a futures position is calculated based on the difference between the price at which the position was opened and the price at which it is closed or settled. For example, if you bought a futures contract at $100 and sold it at $105, you would profit $5 per unit of the underlying asset, multiplied by the contract size and number of contracts.

Can you lose more than your initial investment in futures positions?

Yes, it is possible to lose more than your initial margin deposit in futures positions due to the inherent leverage. Futures contracts are marked to market daily, and if your losses exceed your maintenance margin, you will receive a margin call, requiring you to deposit additional funds to maintain your position. Failure to meet a margin call can result in the forced liquidation of your position.