What is a Futures Market?
A Futures Market is a trading place or a financial exchange where participants can trade (buy and sell) in futures and options contracts. These contracts give rights to the engaging parties to buy or sell pre-determined quantities of a commodity, security, or a currency at a pre-decided price and date. Futures markets usually have set standards, rules, and regulations. The main purpose of trading in the futures market is to hedge the risk that can arise due to the uncertainty of future prices or just for speculation purposes.
Prices of any commodity, security, or currency are uncertain in the future. A trader can enter into a futures contract, agreeing to buy a specific quantity of a commodity at a guaranteed future price on a future date. The date is also certain when the contract will mature. The buyer has both the options available – either take physical delivery of the underlying commodity or security on the maturity date. Or the buyer may opt to settle the contract by receiving or paying the difference amount. This difference amount is the difference between the purchase price and the price that is prevailing on the date of maturity. Thus, all such trades may end up in a profit or loss for the parties to the contract upon expiry or maturity of the contract.
How does the Futures Market Work?
People who actually are in business do most of the Futures market trading of the respective commodities. Such trading is done through a broker. He charges a fee for his services, which is known as commission. Only a small amount is needed while making such a trade. This is unlike stocks, where the full amount has to be paid upfront. Usually, traders need adequate margin money in their accounts to trade which is a small percentage of the total sum. Brokers may ask for a minimum amount of capital with traders to operate a futures account. Futures exchange may specify the delivery location of the deliverable too. In case an alternate delivery location is also mentioned, additional delivery charges for that location can also be mentioned.
Many times traders enter into a futures contract with no intention of taking actual delivery at the time of maturity of the contract. Day traders intend to profit from price fluctuations in a commodity after entering into the futures contract. They use a cash settlement agreement which means the settlement is done by means of exchange of money only, and no physical delivery of the goods or securities.
Futures Markets generally have a regulatory body that oversees their activities and functioning. Commodity Futures Trading Commission (CFTC) in the US and Securities and Exchange Board of India (SEBI) in India are examples of such regulatory bodies. Such bodies are mostly governmental agencies.
Similar to stock options, futures options are a risk management tool for traders trading on a futures exchange. Futures options provide the trader an option to execute the buy or sell futures contract if specific conditions are met in the market. While the contract does give an option to the buyer but does not cast any obligation on the buyer to fulfill the contract. However, if the buyer of the option intends to trade in the underlying asset at the expiry of the contract, the seller of the option will have to oblige and complete the contract.
Futures options are thus less risky than a futures contract. But the right to get the option does involve a cost and the option buyer needs to pay a premium to buy that right. Hence, such contracts become expensive sometimes.
What is the Difference between Cash Market and Futures Market?
The Cash Market and Futures Market both facilitate trading in securities, commodities, and currencies. However, there are many differences between the two.
A trader can buy and sell securities, etc. in a Cash market and trade in them in exchange for cash, take delivery, hold it and then sell it.
But the main purpose of participants in a Futures market is not trading but hedging against future possible risk. Also, traders may participate in a Futures market for speculative purposes. And to earn quick money from the price fluctuations of the security, commodity, or stock.
Ownership of a Company
A buyer of stocks automatically becomes part-owner of the Company of which stocks are bought in a Cash market. He will continue to have ownership rights till the time he does not sell those stocks. In many cases, stocks are transferred even to future generations of the original holder and they become the owners of the company.
This is not so with the buyer of a Futures contract covering a stock. The buyer only holds the futures contract and stocks will have to be traded at the maturity of the contract.
Margin Money and Payment
A participant in a Cash market has to complete the trade only with cash or money. Hence, he will have to keep sufficient liquidity in his accounts to cover his traded value.
In the case of the Futures market, the participants just need to have the required margin money in their accounts to buy the futures contract. The rest amount will be of need at the time of maturity of the contract in case delivery is needed. In the case of a Cash settlement agreement, even the full amount will not be needed. Only the difference amount arising out of the position at the maturity time needs to be settled.
A Cash market allows trade even in a single stock of a company. This is not so in the Futures market. A trader has to buy a minimum lot of securities or a commodity as defined by the exchange.
Bonus, Dividends, and other Stock Benefits
A stock buyer enjoys various benefits that come with a stock- bonus issue of stock, dividends if declared, voting rights, etc.
A Futures contract holder of a stock does not enjoy these benefits.
Difference in Risk
A Cash market participant deals with less risk than a Futures market participant. In the Cash Market, a trader can trade according to the current market prices. He can hold an asset and not sell in case of a fall in the prices of the asset. Also, he can stop buying in case of rising prices and limit his losses.
On the other hand, a Futures market participant deals with higher risk. He will have to execute the contract at the time of maturity or settle his position by paying the difference amount in cash. Such contracts become dangerous in times of falling prices. Because the buyer will have to buy the asset at the pre-determined price. Even if the current market price is much lesser than the contracted one. Similarly, a seller will suffer losses in times of rising prices. He will have to deliver at the pre-determined price at the time of entering the contract and suffer a loss.