- What is a futures contract, and why were they created?
A futures contract involves the delivery of some specific asset from the seller to the buyer at a preset future date and typically trades on regulated exchanges from Sunday afternoon to Friday afternoon, New York time.
In addition to specifying the future delivery date, the buyer and seller also determine the price and quantity for delivery, but the seller does not remit full payment for the asset until the time of delivery. To insure that both the buyer and the seller are financially capable of meeting the contract obligations, each entity must post an initial “margin” deposit at the entry point and a maintenance “margin” amount through the contract holding period.
Futures contracts in the U.S. originally emerged to address the buying and selling of grain. To demonstrate the economic usefulness for futures contracts, please consider the example of a wheat farmer and a flour miller. The wheat farmer expends significant financial resources in the spring of each growing season but has no certainty regarding his future revenue at harvest time. Concurrently, the flour miller may have agreed to a long-term supply contract to deliver flour to local bakeries, but he faces uncertainty regarding the future price of wheat at harvest time.
In this example, when the wheat farmer plants his crop, he may choose to sell his expected crop prior to harvest at a fixed price. Likewise, the flour miller looking to purchase the wheat farmer’s expected crop may reduce his economic uncertainty by locking in a specific raw material cost for his flour processing later in the year. The economic basis of this transaction provides the underlying rationale for futures contracts, allowing both the wheat farmer and the flour miller to reduce their future uncertainties.
In this example, however, the wheat farmer and flour miller would have needed to establish direct contact with one another, and this direct contract would not allow flexibility for the size of the expected harvest or for either party to extricate himself without the other’s concurrence. To alleviate these issues, futures exchanges therefore establish uniform contract terms – including the dates of delivery, price trading increments, amounts of deliverable assets, margin requirements, and trading hours – and flexible, liquid trading venues, allowing either party to reverse his side of the transaction by offsetting his initial position with any third party on any business day prior to the contract’s specified delivery date. In addition, the futures exchange holds each side’s “margin” requirements and facilitates the daily “mark to market” for the respective futures accounts.
Returning to our example, the wheat farmer may experience a crop failure and therefore be unable to meet the delivery terms. He may then buy back the contracts that he had earlier sold, reversing his economic position. The flour miller may have purchased more wheat bushels than he actually needs. He may then sell some of the contracts that he had earlier purchased, similarly reversing his economic position.
On any particular day, commercial supplier and producer interests may reach a buying-selling imbalance. To facilitate a liquid market with well-known prices, third-party traders and investors may enter the market to help achieve a proper balance. These third-party traders and investors may obtain futures exposures in order speculate on price direction, to take advantage of temporary price imbalances that emerge from commercial participants’ positioning, or to hedge asset exposures within their portfolios. The participation of both commercial and speculative traders, even with their diverse objectives, provides the futures markets with excellent liquidity and depth.
Many commentators have written that futures trading represents a “zero-sum game.” In other words, for every dollar that one side makes, the counterparty experiences an equal and opposite loss. While this statement does hold – in that each transaction requires a buyer and seller at a similar price – each counterparty’s goal in a futures transaction may differ. Most commercial participants in futures markets take exposures in order to eliminate future price uncertainty; their main objective does not involve “catching” high or low prices, but rather establishing certainty in their future pricing and supporting their ongoing economic viability.. Their desire for price certainty or “price insurance” provides opportunities for futures investors to capture returns by, in effect, becoming the insurance provider.
While futures contracts did emerge to cover physical commodities, such as foodstuffs and raw materials, their footprint has expanded tremendously. Futures trading now involves contracts tied to a wide variety of financial instruments, including bonds, currencies, and equity indices.
- Where are futures contracts traded?
U.S. futures contracts trade primarily on three major exchanges, all under the CME Group and regulated by the Commodity Futures Trading Commission (CFTC):
- The Chicago Board of Trade (CBoT), which offers trading in U.S. Treasury bonds and grains;
- The Chicago Mercantile Exchange (CME), which features contacts in Eurodollars, the S&P 500 Index, currencies, and livestock; and
- The New York Mercantile Exchange (NYMEX), which hosts markets in energy, precious metals, and copper.
In addition to these major exchanges, other global futures exchanges include the Intercontinental Exchange (U.S.); Euronext.Liffe (Europe); the London Metal Exchange (U.K.); Shanghai Futures Exchange (China); Hong Kong Exchanges and Clearing; and Tokyo Commodity Exchange and Tokyo Stock Exchange (Japan).
Country-specific regulatory bodies monitor trading on international futures exchanges, as with the U.S. CFTC.
As with stock exchanges, futures exchanges offer a fixed number of membership, which grants the ability to trade directly on the exchange. Non-members must place orders through the exchanges’ member firms, typically through futures commission merchants (FCMs), which serve similar roles as broker-dealers in securities trading.
The exchanges regulate contract terms and trading activity, including, crucially, each contract’s relevant margin requirements. The exchanges maintain clearinghouses that handle the settlement of each order. These clearinghouses provide a financial umbrella to protect traders and members against the failure of any individual trader or member. The exchanges publish each contract’s daily “settlement price,” against which FCMs “mark to market” their clients’ accounts each day.
In the past, most trading occurred through an open-outcry system in contract-specific trading “pits,” which involve physical locations on the exchanges’ trading floors. Members active in any given pit may place orders for their clients or for their own accounts, while each firm maintains order desks on the trading floor periphery to receive orders and return trade confirmations.
At this point, electronic trading makes up the majority of futures trading activity. Electronic trading may occur parallel to or in lieu of open-outcry trading and allows for nearly 24-hour trading sessions.
- How do the risk exposures associated with futures compare with those of stocks and bonds?
The volatility of individual futures markets is similar to that of stocks and bonds. Depending upon the individual market, the volatility may be less than that of a U.S. 10-year Treasury bond or more volatile than an over-the-counter growth stock.
Often, investors have encountered stories about incurring large losses or making huge gains in futures markets. These outcomes typically result from extremely high leverage and a lack of diversification. Today in the U.S., the margin requirement for stocks is 50%. Therefore, a $50,000 balance in a margin account enables the investor to purchase $100,000 in stocks, providing a 2:1 leverage ratio.
Futures contracts provide significantly higher internal leverage ratios, averaging approximately 20:1. Since futures contracts involve the future delivery of some product, the two counterparties must post only a limited “margin” collateral to ensure their fulfillment of their future obligations. Commodities exchanges set these margin requirements, primarily based on the relative volatility of each market and the prevailing contract exposure size. As markets become more volatile, the exchanges typically increase margin requirements; as volatility decreases, the exchanges may lower these margin requirements.
Given these higher internal leverage ratios, an investor could establish much higher exposures to a given asset than through a standard margin account. Were an investor to take a 10x leveraged position in a given asset, the leverage would magnify his or her returns by a factor of 10. Therefore, a +2% gain in the contract value would become a +20% gain at the account level, while a -3% loss in the contract value would become a -30% loss at the account level. This arithmetic demonstrates how highly leveraged positions may lead to substantial gains or losses at the account level.
Some investors in the futures markets fail to establish diversified positions. Few stock investors would put all of their investment capital in just one or two stocks. Yet, perhaps due to hearsay or reading an investment newsletter, an investor may take a “flyer” on a single futures market by placing a substantial portion of his or her futures capital into a single market with a high level of leverage. The gain and loss examples provided above would cause the investor to face significant volatility in his or her account value.
In summary, futures investors may avoid undesired risk by limiting their leverage and pursuing adequate diversification. Through this consideration, a futures account’s risk level may match the investor’s objectives and may look similar to that of an equity portfolio, for example. Furthermore, due to their uncorrelated returns vis-à-vis financial assets, futures positions may offer attractive diversification benefits to a traditional portfolio of stocks and bonds.
- How do futures brokerage accounts operate?
A futures brokerage account operates similarly, in certain respects, to a traditional securities margin account, in that the brokerage firm holds all balances and positions on behalf of the client. Clients typically allocate cash deposited in futures brokerage accounts to short-term U.S. Treasury bills, while excess cash may earn some interest from the brokerage firm. The Treasury bills on deposit and excess cash in the account serve as the margin for the long and short futures positions held in the account. Each day, the futures commission merchant (FCM) “marks to market” the futures positions and credits each account with profits or debits as losses that day’s differential in futures contract values, keeping a running total of futures trading (positive or negative) “equity".
- What is the tax treatment for futures contracts?
Section 1256 of the Internal Revenue Code covers the tax treatment for futures contracts traded on regulated U.S. futures exchanges.
Please note that there are certain differences in tax policy when comparing the tax treatment of futures contracts with equity and fixed-income securities:
- Regardless of the holding period for a futures contract, Section 1256 dictates that any net gains or losses over the tax year are allocated 60% to long-term capital gains and 40% to short-term capital gains.
- At year-end, all unrealized gains or losses are “marked to market” and considered as net gains or losses for that given tax year.
- If an investor has a net loss from futures in the current year, he may carry-back the loss for up to three years against the prior years’ futures gains and file an amended return to recapture taxes paid in prior years. As an alternative, he may either apply the loss to other investment gains or carry forward these losses to offset gains in future years.
- In addition to gains or losses from futures trading, any interest earned in a futures trading account will be subject to normal tax treatment for taxable interest income.
- How may active managers (CTAs) provide value to individual investors?
Professional money management involving the use of futures, broadly described as “managed futures” strategies, has developed substantially over the last 30 years. Today, assets under management exceed $200 billion. Both U.S. and international investors, including individuals, trusts, corporate and public pension plans, foundations, endowments, and asset management firms, have allocated capital to managed futures strategies.
Commodity trading advisors (CTAs) oversee managed futures strategies for these clients, typically on a fully discretionary basis. CTA managers may concentrate their strategies in certain markets or offer diversified programs that take positions across a wide range of markets. Investment style range from intraday arbitrage, to calendar or market “spread” trading, to short- and long-term price-driven strategies, and to fundamental macroeconomic strategies. The strategies may involve individual or team collaboration and may employ human decisionmaking or systematic, computer model-driven approaches. Most CTAs take both long and short positions and employ some degree of leverage. Often, their strategies are flexible, allowing individual clients to select their desired level of trading risk.
CTA programs typically include both a fixed management fee and an incentive fee on new profits.
Over time, CTA managers have historically delivered attractive rates of absolute and risk-adjusted returns. Due to their diverse strategies, CTA managers’ returns have shown little correlation either to one another or to financial assets. For this reason, investors may benefit by allocating a portion of their portfolios to CTA programs, which may decrease their portfolio-level volatility and boost their total risk-adjusted returns.
- How may investors participate in managed futures strategies?
Investors may capture the advantages of working with professional futures manager, called a commodity trading advisor (CTA), in three ways: through separately managed accounts, private limited partnerships, or public limited partnerships or mutual funds.
The first method involves opening an individual futures brokerage account in which the CTA has discretion to make all investment decisions. Typically, the CTA will require a minimum account size to allow for full diversification across the markets in which the relevant program trades.
Private limited partnerships provide a popular method for accredited investors, both individual and institutional, to gain exposure to managed futures strategies. Generally, these private limited partnerships feature a lower minimum investment requirement than a separately managed account. The limited partners benefit from simplified tax reporting, receiving a summary Schedule K-1 attachment for their tax return. In addition, the limited liability partnership structure provides an investor with protection against losses greater than the amount invested.
Public limited partnerships or mutual funds offer smaller investors the opportunity to gain exposure to managed futures strategies with a more limited initial investment. Public funds typically operate in a similar fashion to private limited partnerships but may face higher fees and commissions, which the funds build into their cost structures and pass along to investors.
- How is U.S. futures trading regulated?
The U.S. Commodity Exchange Act, which created the Commodity Futures Trading Commission (CFTC), governs the regulation of the U.S. futures markets. The CFTC and a self-regulatory body, the National Futures Association (NFA), oversee all exchanges, futures commission merchants (FCMs), and commodity trading advisors (CTAs) and commodity pool operators (CPOs) in a manner similar to the Security and Exchange Commission (SEC) and FINRA’s regulation of the U.S. securities (stock and bond) markets.
9. Glossary of futures terms
Commodity Futures Trading Commission (CFTC). The regulatory body established by Congress to regulate activity in the U.S. futures markets. The CFTC serves as the futures industry equivalent to the Securities and Exchange Commission, which regulates the securities (stock and bond) markets.
Commodity Pool Operator (CPO). An entity that serves as the general partner of a futures limited partnership. The CPO may also serve as the manager of the fund or may hire other CTAs as managers. Those investment advisors that manage only limited partnership vehicles using futures trading strategies would register only as a CPO. If that advisor were to manage both separate accounts and limited partnership vehicles, the firm would register both as a CTA and a CPO with the CFTC and NFA.
Commodity Trading Advisor (CTA). A professional money manager who trades futures contracts on behalf of his or her clients, analogous to an investment advisor for traditional stock and bond investments. CTAs typically manage futures positions on a fully discretionary basis, either for individual accounts or through larger partnerships or pools.
Futures Commission Merchant (FCM). A brokerage firm that executes, clears, and carries trades for its non-member traders and investors. FCMs may also serve as CPOs and raise funds for management by other CTAs or CPOs.
National Futures Association (NFA). A futures industry self-regulatory body established by the Commodity Futures Trading Commission to oversee registration and monitoring of participants in the futures industry.