Futures Market: Definition, How it Works, and How to Invest

The futures market is a financial marketplace where participants trade futures contracts, agreeing to buy or sell a particular asset at a predetermined price on a specific future date.

Futures markets allow market participants to buy and sell futures contracts through a futures exchange like the Chicago Mercantile Exchange (CME) or New York Mercantile Exchange (NYMEX).

Traders and investors invest in the futures market by researching, choosing a broker, opening an account, and executing trades with proper risk management.

The advantages of futures markets include promoting price discovery, enhancing hedging and risk management, increasing purchasing power through leverage, and providing more opportunities for diversification.

The disadvantages of futures markets include high leverage risk, complexity for beginners, high volatility, high margin requirements, and limited contract sizes.

What is the Futures Market?

The futures market is a standardized exchange-traded market where participants enter into binding contracts to buy or sell an underlying asset at a predetermined price on a specific future date. Futures contracts obligate buyers to purchase an asset, like commodities, currencies, cryptocurrencies, or other securities, at the agreed-upon price and date while obligating the seller to deliver the asset at that time.

Future markets being standardized means that the contracts traded have uniform specifications. A futures contract expiry date is the last day it can be traded, after which the contract is settled either through the physical delivery of the underlying asset or in cash, depending on the agreement terms.

The futures market is centralized, meaning all transactions go through exchanges, such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX).

The futures market is one of the popular “FX keywords” used by investors to hedge against price risk and for speculation to profit from price movements.

The futures market definition finds its origin in the rice fields of Japan. Farmers and merchants needed a way to hedge against price fluctuations. Farmers made binding agreements with rice buyers to sell them rice at a future date with an agreed price. These agreements led to the rise of the Dojima rice exchange in 1710, which traded rice futures contracts.

What is the Importance of Futures Market?

The importance of the futures market lies in its ability to facilitate risk management, improve price stability and market efficiency, and provide reliable platforms for speculation and arbitrage. Futures markets are vital for producers and consumers, allowing them to lock in prices for their goods or inputs and protecting them from adverse price movements.

The Futures market facilitates risk management by allowing businesses and investors to hedge their positions against price fluctuations through hedging. For instance, a farmer worried about declining crop prices can sell futures contracts to lock in a fixed price for their crop in the future, protecting them against market downturns.

The Futures market improves price stability and efficiency by mitigating wild price swings in volatile markets. The continuous trading of futures contracts helps reflect the supply and demand dynamics and market sentiment about the future prices of financial assets and securities, leading to accurate and timely price information.

Futures markets provide a reliable platform for speculation and arbitrage opportunities, allowing investors to diversify their portfolios and profit from future price movements. The efficient and standardized nature of futures markets attracts new willing market participants, creating a large pool of buyers and sellers and increasing liquidity.

High liquidity in the futures markets, according to Charles J. Cuny (1993) in the paper titled ‘The Role of Liquidity in Futures Market Innovations,’ leads to tighter bid-ask spreads, which is good for arbitrage traders or high-frequency traders who take advantage of discrepancies in different markets.

How does the Futures Market Work?

The futures market works by allowing willing market participants to buy or sell standardized futures contracts, binding them to trade specific quantities of a commodity or financial instrument at a specified price on a future date. Executing trades in the Futures market involves defining the terms of the futures contracts, trading them on a futures exchange, and handling settlement and delivery when the contract expires.

The futures exchange standardizes the futures contract specification to ensure liquidity, transparency, and ease of trading. The exchange determines the Futures contract’s size, quality, delivery date, delivery location, price quotation, and settlement method (cash or physical delivery).

Trading on the futures market is done electronically through centralized marketplaces provided by futures exchanges such as the Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE), and Eurex.

Market participants like hedgers open positions on the standardized futures contract to manage risk by locking prices for commodities and securities. Speculators and arbitrageurs open positions on futures contracts to profit from price movements or discrepancies in different markets (arbitrage).

Futures exchanges work with clearing houses to match buy and sell orders based on price and quantity, ensuring all trades are settled by acting as a counterparty. Buyers and sellers must post a margin, a percentage of the total futures contract value. The deposited margin guarantees that both parties will fulfill their obligations in good faith.

Futures positions are ‘marked to market‘ at the end of the trading day, meaning the contract’s value is adjusted to reflect its current market price, and gains or losses are credited or debited to the traders’ accounts.

Futures contracts that expire are settled through physical delivery (a common practice with commodity futures) or cash settlement based on the difference between the contract and market prices at expiration.

How do Futures Contracts Work in the Futures Market?

Futures contracts in the futures market work through standardized agreements between buyers and sellers. Each futures contract specifies the quantity and quality of the underlying asset and, if applicable, the delivery date and location. Participants in the Futures market take either a long position (buy) or a short position (sell). An initial margin, acting as a performance bond, is required to enter a futures contract.

There are five main types of futures contracts. These include commodity futures, financial futures, cryptocurrency futures, environmental futures, and specialized futures like weather or real estate futures.

Commodity futures contracts are based on physical commodities, mainly used by producers to hedge against future price fluctuations. Examples of commodity futures contracts include agricultural futures (such as wheat, corn, soybeans, and livestock), energy futures (such as crude oil, gasoline, and natural gas), and precious metal futures (such as gold, silver, and platinum).

Financial futures are based on financial instruments, often used by corporations and investors to mitigate interest rate risk, currency risk, and equity market exposure. Examples of financial future contracts include interest futures (such as Treasury bonds and Treasury notes), currency futures (such as Euro FX futures, British Pound futures, and Japanese Yen futures), and stock market index futures (such as S&P 500, Nasdaq-100 and FTSE 100).

Cryptocurrency futures are based on digital currencies, often used by speculators to profit from price fluctuations or hedge existing crypto positions. Examples of future contracts for cryptocurrency include Bitcoin and Ethereum.

Environmental futures are based on environmental and carbon credits, and companies mainly use them to hedge against regulatory and compliance costs. Examples of environmental futures contracts include Carbon Emissions futures and Renewable Energy Certifications (RECs) futures.

Futures markets in Forex allow traders to buy or sell currency futures contracts at a set date and time in the future.

Futures contracts are standardized, meaning the future exchange dictates the contract details like quantity of the underlying asset (e.g., 100 barrels of oil), quality specifications (e.g., light sweet crude oil), delivery location (e.g., Waco, Texas), and expiry date (e.g., three months).

Specialized futures are based on less common assets and could slightly differ from the conventional futures definition. Examples of specialized futures include weather futures and real-estate futures.

The futures exchange usually closes the existing contract while simultaneously opening a new contract with a later expiry date for the same underlying asset when the futures contract is nearing expiration to avoid physical delivery of the commodity.

Rolling over a futures contract ensures that investors trading in the futures market extend their positions without interruption if they believe the price trend will continue.

What is Futures Market in Forex?

The futures market in Forex is an auction market that allows market participants to trade standardized futures contracts where the underlying asset is currency pairs. Futures contracts for Forex obligate buyers and sellers to exchange currencies at a specific rate on a specific date in the future. Traders, investors, and businesses use Forex futures for hedging and speculation.

Forex futures are traded on electronic platforms provided by FX brokers through centralized futures exchanges like the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE).

Most Forex futures contracts are settled in cash rather than physical currency delivery, and their expiration dates are often set at quarterly intervals, i.e., March, June, September, and December. The most commonly traded Forex futures involve the major Forex pairs, e.g., EUR/USD, GBP/USD, USD/JPY, AUD/JPY, USD/CHF, and USD/CAD.

Traders and investors trading Forex futures use leverage to control large positions with smaller capital, enabling them to amplify their gains. The margin requirements for trading Forex futures are usually lower than the stock market requirements.

How can Futures Market affect the Forex Market?

The futures market can significantly influence the Forex market through hedging, price discovery, and liquidity injection from increased speculation and arbitrage opportunities. Futures markets also influence the transparency of Forex markets, which is good for regulations and impacts market sentiment and interest rate expectations.

Futures markets are mainly used by companies and large investors to hedge positions. Increased hedging activities in the Forex markets influence the supply and demand dynamics for both the spot and futures markets, affecting the currency values.

Forex futures markets reflect the market expectations regarding future currency values. Many traders look at the Forex futures prices to gauge the currency direction in the spot market, leading to position adjustments as participants align their spot positions with the anticipated future movements. The alignment of spot positions with anticipated movements leads to price discovery and better market efficiency, as Margaret Bray (1979) observed in the paper titled ‘Futures Trading, Rational Expectations, and the Efficient Markets Hypothesis.’

Forex futures markets increase the number of buyers and sellers in the market as more participants look to profit from changes in currency exchange rates. Forex futures attract arbitrage traders who exploit price discrepancies between spot Forex prices and futures prices to profit. The high number of buyers and sellers in the market increases market liquidity and reduces volatility, thereby contributing to an efficient market.

The regulated nature of Forex futures markets helps increase transparency and oversight in the spot Forex market by making it easier to identify manipulations.

According to a research paper by Marco Haase et al. (2016) titled “The Impact of Speculation on Commodity Futures: A Review of the Findings of 100 Empirical Studies,” excessive speculation affects commodity prices by driving them higher and increasing volatility. The study suggests that monitoring speculation levels helps market regulators design better regulations to detect price manipulation and ensure market stability for all the industry’s players, from traders to banks to Forex brokerage firms.

What are the Best Futures Trading Brokers in Futures Market?

The best futures trading brokers in the futures markets are listed below.

1. NinjaTrader: Best for advanced charting and trading tools. NinjaTrader is ideal for active traders who use automated algorithmic trading strategies.
2. Interactive Brokers: Best for low-cost trading, a wide range of markets, and advanced trading platforms. Interactive Brokers is ideal for professional and active traders.
3. TradeStation: Best for customizable strategies, extensive charting tools, and competitive pricing. TradeStation is ideal for active traders and those who rely on technical analysis.
4. E*TRADE: Best for intuitive platform, competitive rates, and strong customer service. E*TRADE futures trading broker is ideal for beginners and intermediate traders.
5. TD Ameritrade: Best for advanced trading tools, extensive educational resources, and robust platforms. TD Ameritrade is ideal for both beginners and advanced traders.
6. Charles Schwab: Best for user-friendly platform, strong customer support, and comprehensive educational resources. Charles Schwab is ideal for beginners and experienced traders.

How to Invest in Futures Market?

To invest in the futures market, traders and investors must open a trading account with a futures broker, develop a futures trading strategy, buy or sell a futures contract at the market price, and implement risk management strategies.

First, learn about futures contracts, how they work, factors influencing their prices, and fundamental knowledge about their underlying assets. Second, research and compare brokers, considering commission structures, platform features, and account margin minimums.

Third, open a futures trading account and fund it to meet the margin requirements. Define the investment goals, risk tolerance, and time horizon for trading futures contracts, then create a trading strategy. Set clear entry and exit rules for future trades and start trading. Monitor the market conditions and be ready to adjust positions in case of any major developments, like economic news. Manage the trading risks using stop-loss orders, position sizing, and avoiding overleveraging.

Following the trading plan and strategy is the only way to reduce the risks of investing in the futures market.

Is Futures Market Good to Invest?

Yes, the futures market is good to invest in for traders who understand how it works, the risks involved, and how to use leverage to amplify profits. Futures markets are usually highly liquid and offer multiple speculative and arbitrage opportunities, enabling investors to profit when their predictions are accurate.

Futures markets enable leverage, which allows traders to control larger contract sizes with smaller amounts of capital. When executed according to the trading plan, leverage maximizes the investment returns.

Futures markets grant investors access to a wide range of assets, including indices, commodities, and currencies, providing more opportunities for diversification.

Futures markets allow traders to hedge their positions against potential losses and operate almost 24 hours a day, giving them flexibility to trade whenever they want.

Futures markets can be a bad investment due to the risk of overleveraging, which leads to substantial financial losses. Other factors that lead new and inexperienced investors to lose money when investing in futures are high price volatility and the complex strategies required when developing trading strategies.

What are Examples of Futures Markets?

Examples of futures markets are listed below.

1. Soft commodity futures: Refers to futures contracts that derive their value from agricultural products like coffee, cocoa, sugar, cotton, and livestock. Soft commodity futures contracts are traded on exchanges such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE). Coffee producers lock in a price for their future coffee harvest by selling coffee futures contracts, ensuring they receive a stable price despite market fluctuations.
2. Hard commodity futures: Refers to futures contracts that derive their value from natural resources mined from the ground like gold, copper, crude oil, natural gas, and iron ore. Hard commodity futures contracts are traded on exchanges like COMEX or the London Metal Exchange (LME). Investors buy gold futures to speculate on rising gold prices. The investor sells the futures contract for a profit before the expiry date if the price of gold increases.
3. Index futures: Refers to futures contracts that derive their value from financial indexes such as the S&P 500, Nasdaq, or Dow Jones. Index futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME). Investment managers buy S&P 500 futures to hedge against potential declines in their stock portfolio. Gains from the futures contracts offset portfolio losses If the market drops.
4. Currency futures: Refers to futures contracts that derive their value from the underlying currency exchange rate like EUR/USD, GBP/USD, USD/JPY, and USD/CHF. Currency futures contracts are traded on centralized exchanges like the Chicago Mercantile Exchange (CME). Companies expecting to receive payment in euros buy EUR/USD futures to lock in the current exchange rate, protecting against potential depreciation of the euro.
5. Interest futures: Refers to futures contracts that derive their value from the underlying interest-bearing security like government bonds, Treasury bills, and Treasury notes. Interest rate futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME). Financial institutions buy Treasury bond futures to hedge against rising interest rates, which would negatively impact the value of their bond holdings.
6. Cryptocurrency futures: Refers to futures contracts that derive their value from the underlying cryptocurrencies like Bitcoin and Ethereum. Cryptocurrency futures contracts are traded on exchanges like Binance, Coinbase, and Kraken. Investors buy Bitcoin futures to speculate on the future price increase of Bitcoin.

What are the Advantages of the Futures Market?

The advantages of the futures market are listed below.

• Price discovery: Futures markets facilitate the process of price discovery by allowing market participants to express their opinions on future prices.
• Risk management: Futures contracts enable hedging against price volatility in various asset classes, reducing the overall portfolio risk.
• High liquidity: Futures markets experience high liquidity that ensures tight bid-ask spreads and reduces transaction costs for traders.
• Increased buying power: Leverage amplifies potential returns by allowing traders to control a larger position with a smaller investment.
• Diversification: Futures contracts are available on various assets, including commodities, indices, and currencies, providing more diversification opportunities.

What are the Disadvantages of the Futures Market?

The disadvantages of the futures market are listed below.

• High leverage risk: Leverage amplifies both gains and losses, leading to significant financial losses for inexperienced traders.
• Complexity for beginners: Futures trading involves complex strategies and requires a deep understanding of the markets and trading techniques.
• Limited to specific contract sizes: Traders cannot customize contract sizes and other specifications, which is a disadvantage in certain market situations.
• Margin requirements: Traders must maintain a certain amount of capital in the trading account to cover potential losses. If the account balance falls below the required margin level, they must close the position at a loss or deposit more funds.
• High volatility: Futures markets are highly volatile, making it challenging to predict price movements.

What are the Risks in the Futures Market?

The risks in the futures market are listed below.

• Overnight risk: Futures markets are open almost 24 hours a day, but prices gap significantly during market closures, leading to losses.
• Counterparty risk: Traders risk losses if the clearing house defaults on its obligations.
• Liquidity risk: Futures contracts that experience low liquidity make it challenging to enter or exit positions at the desired price levels, resulting in slippage.
• Market risk: Traders risk significant financial losses due to adverse price fluctuations in futures contracts.
• Regulatory risk: Changes in regulatory policies, margin requirements, or trading rules increase trading costs and restrict trading activities.

What is the Difference between the Futures Market and Spot Market?

The difference between the futures market and the spot market lies in the timing of delivery and settlement of the underlying asset. Futures markets involve buying and selling assets at a specified price on a predetermined future date. Spot markets involve the immediate exchange of assets for cash ‘on the spot’ or within a short period, typically within two business days.

Spot markets and futures markets both offer multiple trading opportunities for speculation and arbitrage. However, most investors use “future vs. spot market” to hedge against wild price fluctuations in other assets.

Futures markets also offer higher leverage options to maximize trading profits than spot markets.