How does the futures market work?
The futures market refers to the market in which futures contracts are traded. Futures contracts concern transactions of underlying assets (either commodities or financial securities) that are going to take place sometime in the future.
If you are planning on investing in the futures market, the first thing you will need to do is register an account with a clearance house and make sure that you have some funds or deposits at your disposal. A clearance house is often attached to a stock exchange whose responsibility is to monitor the transactions in the futures market and to decide the settlement price, based on which the market is cleared.
You buy or sell a futures contract at the current market price. This price will be written on the contract and is called the futures price. If you want to buy something in the future, you are referred to as being in a long position. Sellers are in a short position. On the expiration date stated on the contract you are obliged to sell or buy the goods, as specified. You can close out the contract by taking an opposite position – buying or selling – before or at least on the expiration date. If you fail or forget to take the required action before or on the expiration date, then you need to be prepared to receive or deliver the goods on that date. In fact, investors in the futures market don’t often hold the futures contract until the expiration date.
An important feature of the futures market is the mechanism of mark-to-market (or daily settlement). Daily settlement means that all futures transactions are to be cleared on a daily basis in the futures market. The daily settlement is based on the difference between the settlement price and the futures price at which you buy or sell. As noted above, a clearance house decides the settlement price based on which the market is cleared. If you’re in a long position in the futures market (where you’ll buy the underlying asset sometime in the future), at the end of the transaction day you compare the futures price with the settlement price. If the settlement price is higher than the futures price you paid, then you make a profit:
(settlement price – futures price) \(\times\) total quantity of the transaction
The increase in the value of the transaction will be added to your account by the end of the trading day. And the same amount of money is deducted from the account of the person who has made a loss from selling this futures contract.
The mechanism of daily settlement – start each day with a new price – provides investors with flexibility to adjust their investment strategies in time. Looking back to our introduction to forward contracts, can you see other ways in which a futures contract is more flexible than a forward contract? Share your thoughts with your fellow learners in the comments section.