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Kinds of Futures Contracts
Kinds of Futures Contracts - Introduction
Futures contracts are one of the most important and one of the earliest financial instruments in the world today. Futures contracts are created to facilitate the risk management and trading of commodities and financial securities in almost every market in the world. So, exactly how many kinds of futures contracts are there in the world today?
This tutorial shall explore the general classes as well as the different kinds of futures contracts that are being traded around the world.
Two Main Kinds of Futures Contracts
All futures contracts traded around the world can be classified broadly under one of two broad categories; Commodity Futures or Financial Futures. Commodity Futures, also known as Commodities Futures, are futures contracts that are written mainly on actual physical products while Financial Futures are futures contracts that faciliate in the trading of non-physical, financial products such as interest rates and publicly traded company shares.
The picture below summarizes the main kinds of futures contracts under each category.
Kinds of Futures Contracts - Commodity Futures
Commodity Futures include 5 main classes; Grains Futures, Metal Futures, Energy Futures, Softs Futures and Livestock Futures. As you can see from the picture above, commodity futures basically covers the trading of physical, deliverable, products and goods. In fact, commodity futures are the earliest form of futures contracts created in the world. There are now futures contracts being traded for almost every imaginable commodity in local futures markets around the world. The list provided here is not an exhaustive list as it merely covers the most popular kinds of commodity futures being traded around the world in global markets and the US commodities market in order to give you an idea what commodity futures are.
Commodity futures contracts are commonly physically delivered (physical settlement) with both parties of the contract obligated to trade the underlying asset at the futures price upon expiration of the commodity futures contracts and are typically used between producers of a commodity and buyers of those commodities for production purpose. However, there are also plenty of price speculators and short term hedgers in the commodity futures market which may not be interested in the eventual delivery of the physical commodity. These futures traders typically close their positions before expiration which takes up precious physical commodity trading futures contracts from futures traders who actually intend to trade the underlying asset. As such, Cash Delivered (cash settlement) commodity futures contracts have also been created for most of the popular commodity futures markets. Cash delivered commodity futures contracts take the burden of being the go-between for the actual delivery of the physical commodity away from the exchange while providing the same level of price protection and hedging. As such, many commodity futures exchanges are beginning to favor cash delivered rather than physically delivered commodity futures contracts.
In commodity futures trading, the long is the party that is obligated to buy the underlying asset while the short is the party that is obligated to sell and deliver the underlying asset to the long upon expiration. Before expiration, just like all futures contracts, commodity futures contracts undergo daily settlement where the long profits when futures price rises and the short profits when futures price falls.
Read more about Commodity Futures.
Let's take a brief look at each of the different kinds of commodity futures.
Grains futures covers the trading of grains used for food as well as raw material for other processed products such as corn oil. The most popularly traded Grains futures are Corns, Soybean, Rice, Oats and Wheat. Each commodity comes with its own specific futures market with individual futures contracts and markets created for their trading. Individually, they are known as Corns Futures, Soybean Futures, Rice Futures, Oats Futures and Wheat Futures. Each of them has their own contract specifications even though most of them comes in the contract size of 5000 bushels.
The price hedging and price discovery function of grains futures allows the price of grain based food in the supermarkets, such as oatmeal, corn oil and bread, to be fairly predictable and consistent as producers and processors agree on the price of raw materials through grains futures ahead of time. For instance, a corn oil producer can enter into a corn futures contract with a producer of corn an entire harvest ahead of time in order to fix the price of purchase and therefore prevent any price fluctuations on the raw material that might eventually affect the price of corn oil.
Metal futures cover the trading of precious metals such as gold, silver, copper, palladium and platinum. Precious metals market is an extremely volatile one around the world. Producers of products that use precious metals such as computers and televisions as part of their components simply cannot risk the volatility in price of these essential precious metals. This is where metal futures contracts come to the rescue. By setting a fixed trading price for these precious metals ahead of time, producers can be assured of the price of their raw materials and therefore protect consumers from price volatility of consumer goods.
Each metal futures are known by its own name; Gold Futures, Silver Futures, Copper Futures, Palladium Futures and Platinum Futures, with mini-sized contracts for the most popularly traded ones such as Gold-mini and Silver-mini.
The Energy Futures market is an extremely important one that affects modern living directly. Without stable energy prices, modern living would be extremely inconvenienced as families would find it impossible to plan for their family budget, leading to inefficiencies of spending which will then impact the current consumer driven US economy. Energy futures cover everyday energy usage items like heating oil for the winter, electricity for homes, gas for cars and of course the raw material from which all of these are derived from; crude oil. The energy futures market is also an extremely vibrant and liquid one as almost every energy futures contracts are heavily traded for speculative as well as hedging purpose. Participants include speculators to producers of oil related products to producers of oil. Some of the most watched energy futures prices include Brent Crude and Light Sweet Crude which are announced on financial TV every single day.
Softs Futures market, also known as Soft Commodities Market, is where commodities such as cocoa, coffee, cotton, orange juice, sugar and lumber are traded in the US market. Collectively, these commodities are known as "the softs". Other soft commodities such as rubber are traded in other soft commodities markets around the world. Like all agricultural products, the softs futures market can be an extremely volatile one with surprising bad news due to weather and natural disasters affecting output significantly. Amongst the softs futures, cotton futures are the least volatile and therefore not very exciting for speculative futures traders. As soft commodities such as cocoa, coffee and orange juice are not daily essentials nor are they necessary raw material for essential products, softs futures prices rarely hit the wires nor do they cause as much concern as energy futures or grains futures.
Softs futures contracts are known in their own names individually such as Cocoa Futures, Cotton Futures, Orange Juice Futures, Sugar Futures and Lumber Futures.
Livestock futures, also known as Hog/Cattle Futures or simply the "meats", deals primarily in beef and pork products as well as live cows and pigs (known as "hogs" in USA). Livestock futures is another extremely important futures market that deals with the food that we eat. Without livestock futures, the meats that we buy may undergo large price fluctuations like what the hogs market in China experienced back around 2007 to 2009 with skyhigh prices one season and rock bottom prices the next. Indeed, futures contracts are especially important in keeping the price of food stable. There are four main types of livestock futures; Live Cattle Futures, Lean Hog Futures, Feeder Cattle Futures and Pork Bellies Futures.
It is interesting that trading livestock futures aren't particularly hot amongst the speculative futures traders. Most professional speculative futures traders stay away from livestock futures and stick to other futures markets such as energy futures. Some reasons quoted for this lack of interest in the US livestock futures market is that it is fairly illiquid and that it is typically dominated by a couple of big institutional players.
Kinds of Futures Contracts - Financial Futures
Financial futures contracts are created for the trading of non-physical financial products which would otherwise have no means of being traded. For instance, an index is merely a number representing how the stocks covered by the index is moving. The index itself is a non-physical, non-tradable number and investors who wants to invest in all of the stocks covered by an index used to have to buy all of the stocks in the proportion represented by the index. This results in extremely high cost and made trading an overall portfolio or market covered by an index impossible for retail traders. With the invention of financial futures, non-physical "assets" such as an index becomes directly tradable with cash being exchanged at the end of the contract between both parties instead of a physical asset. Financial futures truly opened up a whole new way of profiting from the market and hedging equities positions.
However, not all financial assets are non-deliverable. Some financial futures actually have assets that can be exchanged hands upon maturity; Stocks, Bonds, Currency. These are all "non-physical" financial assets that can be delivered and traded upon maturity of the futures contract. As such, financial futures contracts also comes in both physical settlement and cash settlement contracts depending on the underlying. In fact, there are also cash settled contracts for deliverable financial assets such as stocks. This is to reduce the exchange's burden of committing to the overseeing of the process of exchange of the underlying asset while catering to the needs of speculative futures traders or hedgers who would typically not want to take delivery on the underlying anyways.
Like commodities futures, the long in a financial futures contract is obligated to deliver to the short the underlying asset upon maturity. For underlying assets that are non-deliverable, the long would simply profit from the shorts when the price of the underlying goes up and the shorts profiting from the longs when the price of the underlying goes down.
Read more about Financial Futures.
Forex futures, also known as "Currency Futures", are futures contracts securing the transaction of a certain amount of currency at a fixed price between two parties. Forex futures is a 24 hours a day, 7 days a week non-stop global market and is one that is attracting a lot of attention from retail traders lately due to the possibility of trading after office hours as well during weekends. In fact, the forex futures market is the biggest financial market in the world today. Forex Futures allows forex traders to trade forex on leverage without which trading the currencies directly would involve extremely high capital requirements. Forex futures made it possible for traders with only a few hundred dollars to start and this low barrier to entry also contributed to the popularity of forex futures lately.
Apart from speculative purposes, forex futures are widely used by international corporations for hedging against foreign exchange risk. Foreign exchange fluctuations can directly affect the amount of revenue receivable in the home country by international corporations operating overseas. Forex futures offer the extremely valuable function of hedging against fluctuations in the forex market thereby increasing the stability of income received from foreign currencies. Almost all major currency pairs comes with forex futures and sometimes even forex options and options on futures.
Interest Rate Futures
Interest rate futures are futures contracts based on various interest paying bonds like the US treasuries or T-bills. So why aren't they called "Bonds Futures" instead? That's because the purpose of interest rate futures is actually for hedging against interest rate risks. It is based on the principle that bond prices move inversely with changes in interest rates; when interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Borrowers can hedge against borrowing cost increases by going short on interest rate futures thereby profiting from the drop in bond prices when interest rate rises in order to offset the higher costs of borrowing. Going short on an interest rate futures also allow the seller to lock in a fixed forward borrowing rate. If a borrower expects to borrow at a certain rate at a certain future month, that borrower can simply short an interest rate futures expiring on the expected borrowing month. This will commit the borrower to borrowing from the long at that rate which will provide protection against interest rate fluctuations.
Index futures are one of the most important form of financial futures in the world today. Index futures "magically" transform numbers that has no real asset behind them into tradable, profitable, numbers. This means that for the first time, traders and investors need not buy all of the stocks in an index in order to invest in the overall market or whatever the index covers thereby reducing capital committment in investing in an overall portfolio of stocks. Index futures also allow institutional investors investing in a full portfolio of stocks to hedge their portfolio risk by shorting index futures against the index which represents their portfolio. This greatly increases investment security and eliminates the need to reallocate in and out of equities in order to protect one's portfolio. Today, there are index futures available for trading on almost every major index around the world. The invention of E-mini index futures contracts, which are index futures with just a fraction of the contract size, further lowers the capital requirement for index futures trading and opens the door of index futures trading to small retail traders with very small fund sizes. Such retail investors would not have the fund size to invest in an overall portfolio of stocks, neither would some of them have the fund for full index futures contracts. Today, there are also E-mini index futures available for almost every major index in the world. Some popular index futures include the S&P500 E-mini Index Futures and the Nikkei225 Index Futures.
Single Stock Futures
Single stock futures, simply known as SSF, are futures contracts offered on publicly traded company stocks. Heavily traded stocks like AAPL has single stock futures available for trading. Single stock futures are normally physically delivered futures contracts with the underlying stock delivered from the short to the long by expiration. However, with the advent of stock options for stocks in the US market, single stock futures just isn't that popular as it is too complex for small retail traders and too focused on one stock to attract the attention of institutional investors who needs index futures more than single stock futures. Nevertheless, single stock futures continue to be an important derivative instrument completing the range of derivative instruments available for stocks.
Single stock futures usually come with contract size of 100 shares denominated in dollars, which is the same as stock options in order to make these derivative instruments cross compatible when used in combinations.