Last Updated on 13 April, 2021 by Samuelsson
Trading futures has a lot of benefits, such as low cost of execution and commissions, adequate liquidity, up to 10x leverage, enough volatility, ease of short-selling, better market efficiency, and a unique way to hedge against risk. Considering all these benefits, you may want to know what the futures market is.
The futures market, also known as a futures exchange, is a marketplace where people can buy or sell futures contracts and options on futures contracts. A Futures contracts is a standardized contract to buy or sell specific quantities of an asset at a presently agreed price, to be delivered on a specified time in the future.
There are many things you may want to know about the futures market, so keep reading to find out more about the market, the history, and how futures work.
History of Futures Markets
Let’s begin by having a look at the history of futures markets!
Before Common Era
The origin of futures market dates back to the 18th century BC, when the sixth Babylonian king, Hammurabi, created the code of Hammurabi — a code that allowed the sales of goods at an agreed price, to be delivered on a future date. The contracts were usually put in writing, and there was always a witness to the contracts.
Later, in the 4th century BC, Aristotle wrote about the story of Thales, a man from Miletus who was good at forecasting olive harvest. Thales predicted that the olive harvest would be very good the following autumn and confidently used his prediction to secure future contracts for the use in olive presses.
He agreed with olive press owners to pay for use of their olive presses long before the harvest was due. Because the harvest was in the future and no one knew how the harvest would turn out, he was able to negotiate low prices — the olive press owners were willing to hedge against the possibility of a poor harvest and low demand for their presses.
Eventually, the harvest was plentiful as Thales had predicted, and there was a huge demand for the use of olive presses. As the demand for olive presses was more than the available olive presses, Thales was able to sell his contracts for the use of the olive presses at higher rates and made a lot of money.
In the modern era, it could be said that the first organized futures market started in Japan, at the Osaka Rice Exchange in the early 18th century. But there were elements of futures trading in the 16th century Royal Exchange in London. Then, traders were conducting businesses in coffee houses in London; they would draw a ring on the floor to serve as their trading floor.
In the early 19th century, the first futures market in the US was established in Chicago. Close to the cattle home and the farmlands in the Midwest, Chicago is naturally the center for the transportation, distribution, and trading of agricultural produce, so it makes sense that a market that would help farmers and merchants to hedge against price fluctuations would be situated in Chicago. Although forward contracts were already in place then, the rate of default was very high, necessitating the establishment of an exchange that would standardize the contracts and ensure full settlements.
So in 1848, the Chicago Board of Trade (CBOT) was established, and the first contract to trade on the new exchange was corn. Initially trading as forward contracts, it became standardized in 1865.
In 1874, the Chicago Produce Exchange was formed, but in 1898, it would be renamed the Chicago Butter and Egg Board. In 1919, the Chicago Butter and Egg Board was reorganized into the Chicago Mercantile Exchange (CME).
Meanwhile, a regional market was founded in Minneapolis in 1881, and in 1883, it traded futures contracts for the first time. It would later become the Minneapolis Grain Exchange (MGEX) — the only exchange that deals on hard red spring wheat futures. Around the same time, commodity futures exchanges were established in New York to handle trades in energy and metals contracts — the New York Mercantile Exchange (NYMEX) and Commodity Exchange Inc. (COMEX).
Across the Atlantic, in 1877, the London Metal Market and Exchange Company — London Metal Exchange — was established for merchants who deal on metals. Initially, only copper was traded on the exchange, but zinc and lead would later be added. It was closed during the Second World War but would open again in 1952, and with time, aluminum, nickel, and steel were added.
In the Indian subcontinent, futures trading started in Bombay and Calcutta in the 1870s. With the influence of the British Empire, Bombay Cotton Trade Association established a futures market in 1875 to trade cotton contracts. At about the same time, standardized opium futures contracts were already trading in Calcutta. With the establishment of the Calcutta Hessian Exchange in 1919, raw jute and jute goods futures contracts also started trading in Calcutta.
After the international gold standard was abandoned in 1971, the CME set up the International Monetary Market (IMM) division to provide futures contracts on foreign currencies like the British pound, Japanese yen, Canadian dollar, and Swiss franc. It marked the beginning of financial futures contracts. — futures contracts on financial products, such as currencies, stocks, and interest rates.
At present, there are futures contracts for stock indexes, single stocks, interest rates, volatility, bonds, and weather, in addition to commodities like agricultural produce, energy, and metals. Although futures trading started with agricultural produce and other commodities, the futures market now has gone beyond commodities. Financial product futures have outgrown the traditional commodities, trading more $1.5 trillion per day, as of 2005. These financial futures contracts play a huge role in the global financial system.
Initially, all futures exchanges were using the open outcry system(covered later), but with the advent of the internet, most, if not all, exchanges now adopt the electronic trading system. The electronic system started with the CME’s Globex trading platform in 1992, but now, every futures market has an electronic platform of some sort.
Functions of the Futures Market
Futures exchanges are organized in a way that provides vital economic functions. From stabilizing farmers’ income and corporate productivity to facilitating financial transactions around the world, futures play a major role in the world’s economy. The following are some of the functions of a futures market:
1. Market Value Discovery
The futures exchanges constitute a free market for trading expected future prices of both physical assets (commodities) and non-physical assets (financial securities), thereby helping the underlying industries to find the right price for the products. Thus, the futures market plays a role in the determination of the market value of the assets that trade on it.
Commodities prices are determined by the market forces of demand and supply on the futures exchanges and are communicated around the world. With the information about the present futures prices, stakeholders can estimate the future price of any given commodity, which can help them in making many political and economic decisions.
2. Providing Liquidity
The exchanges help to bring buyers and sellers together in one place so that trades can easily be made. A buyer doesn’t need to go looking for a willing seller before executing a trade, and neither does a seller have to search for a willing buyer first. The huge number of speculators in the market means that there are enough players to provide enough liquidity.
3. Standardized Marketplace
Apart from ensuring adequate liquidity, futures exchanges provide organized marketplaces with rules, regulations, and settlement procedures. First, the contracts are standardized, so every trader knows exactly what he’s dealing with. Then, there are criteria to meet before initiating a trade.
Furthermore, each exchange has a clearinghouse, which ensures that all transactions are fulfilled. The clearinghouse help to maintain stability in the market by settling all the changes in the traders’ accounts at the end of each trading day and acts as the other party in all transactions.
4. Risk Management
The futures market helps businesses, farmers, fund managers, and individual investors to manage risk involved in their various businesses or investments. These entities come to the futures market mainly to hedge their positions against fluctuations in the prices of their assets of concern.
In fact, the government of countries that rely a lot on the importation or exportation of certain commodities (crude oil, for example) also use the futures market to hedge against price fluctuations. In the same way, a fund manager or an investor who is worried about the effects of volatility on his portfolio will approach the futures market to protect his investment from adverse price movements.
5. Speculation Opportunities
There are some traders whose main aim is to benefit from changes in the prices of assets on the futures markets. These sort of traders don’t come to the futures market to hedge the positions they have elsewhere; they’re in the market purely for speculation, and they are called speculators.
Speculators are very important in providing adequate liquidity in the market. With enough liquidity, the bid-ask spread of those commodity prices is narrower, reducing fluctuations in the prices of those commodities. This way, the speculators help to stabilize prices.
How Futures Work
The primary purpose of the futures market is to provide a liquid and well-regulated marketplace where businesses can go to hedge against wide fluctuations in the prices of their assets of concern. To understand how futures work, we need to discuss a practical example.
Assuming the price of wheat in the futures market is $10 per bushel, and it costs a wheat farmer about $8 to produce a bushel of wheat. If this farmer thinks that the price of wheat may go down (below the $8 cost per bushel) by the time he harvests his wheat six months from now, he can use wheat futures to hedge against that perceived risk.
Let’s say that this farmer is expecting to harvest about 20,000 bushels, and a contract of wheat is 5000 bushels. He can sell four contracts of wheat futures, which are presently selling at $10 per bushel, and keep rolling the contract (see below) over until his harvest time. With this action, he has locked in $2 per bushel as profit. When the time comes, the exchange would ask him to deliver the asset to the buyer that needs the wheat.
The buyer can be a flour company which needs wheat for flour production. The wheat company must have believed that the price of wheat would go up, so it hedges against that by buying wheat futures to ensure wheat supply at a perceived fair price.
One interesting fact about the futures market is that the farmer and the flour company never look for who would take their trade — the exchange does that for them. In fact, it is even possible that each of them entered the trade at different times, and the exchange’s clearinghouse or a speculator (who closed his trades at some point) held the other end of the trade at some point during the life of the contract. When the flour company entered the trade, it was interested in taking delivery of the asset, so it held the trade till expiration, just like the farmer.
Trade Management in Futures
As you can see from the example, there three ways to manage a trade when you are dealing with futures:
- Offsetting the position before expiration
- Rolling over to the next contract
- Holding the contract till expiration
1. Offsetting the Position Before Expiration
Speculators always close their positions before expiration. They do this to avoid dealing with settling an expired contract, which might involve physical delivery of the asset. Closing a position implies taking an equal and opposite transaction. A four-contract long position in wheat is offset by going short four contracts of wheat.
2. Rolling Over to the Next Contract
Hedgers and speculators can keep a contract beyond expiration by rolling the position with another contract that is further in the future before the current contract expires. This is done by simultaneously offsetting the current position and opening a new one in the next contract month.
3. Holding till Expiration
For commodity hedgers who want to take or make delivery of the asset, contracts are held till expiration. Some speculators also mistakenly hold their contracts till expiration. For the most part, contracts held till expiration have to be settled either by physical delivery or cash settlement. However, those who don’t want physical delivery but, by one reason or the other, held till expiration, also have a way out — retendering.
Brokers often notify traders when the expiration date is approaching, especially if the contract is settled by physical delivery. But if knowingly or unknowingly, a trader finds himself in a position of dealing with a delivery, but wants to opt out, he can retender the asset by selling the contract. The trader will have to pay a fee for this though.
If a contract will be settled by physical delivery, it will be stated in the terms of the contract. The contracts that often require settlement by physical delivery include wheat, cotton, oil, livestock, and corn, but only about 2% of these contracts are actually delivered.
Usually, when a contract reaches expiration, the exchange will state the First Notice Day (the first day to assign delivery to the buyer) and the Last Trading Day (the last day the contract can trade). Between the First Notice Day and the Last Trading Day, the seller would have delivered the asset to the buyer.
Note that nearly all brokers liquidate your position for you, in case you held it through delivery. In other words, you don’t need to take delivery of the underlying asset!
Most contracts are settled with cash on expiration, and they include equity futures, volatility index futures, and other contracts that cannot be settled by physical delivery. For these types of futures, traders rarely hold till expiration — they either offset or rollover their positions before expiration.
Although commodity futures can be physically delivered, an exchange may adopt cash settlement or at least make cash settlement an option. Whatever settlement option that is available for a contract will be stated in the terms of the contract.
Setting the Settlement Price
On the expiration of a cash-settled contract, all open positions are automatically closed. The exchange will stipulate the settlement price for the contract. The settlement price is often based on price movement on the Last Trading Day. Every exchange has a clearinghouse that oversees the settlements.
For long trades, positions that were bought below the settlement price will be closed in profit, while positions bought above the settlement price would be closed in loss. The opposite is the case for short trades, and everything will reflect on the account balance.
Because futures contracts are marked-to-market, at the end of every trading day, the profits and losses for the day are settled. Traders whose margins are falling below the maintenance margin are required to boost their accounts. It is done like this each day until the contract expires.
It is worth noting that before being allowed to trade on a futures exchange, the trader has to deposit in his account with exchange an amount that covers the initial margin and, to some extent, the variation margin. It’s the variation margin that is used for the daily settlements.
Difference Between Futures contracts and Forward Contracts
Futures contracts and forward contracts are closely related because both represent an agreement to exchange the specified quantity of an asset on a future date, at a pre-agreed price. Despite their similarity, there are many areas in which they differ. Here are some of them:
Futures contracts trade on the exchanges which serve as secondary markets — with no direct involvement of the people who initiated the contracts. Whoever is interested in any particular contract buys or sells it on the exchange without knowing who is at the other end of the trade.
On the other hand, forward contracts trade over the counter, directly between the primary initiator and the counterparty. Thus, the market for forward contracts is the primary OTC market, where both parties deal directly with themselves.
For a forward contract to happen, the parties involved will have to find each other before they can agree on a deal. In other words, there’s no readily available counterparty when one wants to make a deal, so the fellow will have to actively search for someone who is interested in reaching a deal with him. For example, if a wheat farmer wants to have a contract for the sale of his produce, he needs to look for a wheat user who’s interested in the contract before a deal can be done.
Futures contracts, on the other hand, trade on several exchanges where buyers and sellers aggregate to make trades. And with the presence of speculators, liquidity is not an issue.
Parties to the Contract
In a forward contract, the contract is directly between the buyer and the seller of the underlying asset. That is, the seller does not only agree to sell the asset to the buyer on the agreed date but also has to make sure the asset is delivered to the buyer on the agreed date. The buyer is expected to make payment and take delivery of the asset.
The parties in a futures contract don’t directly interact with each other; instead, they interact with the exchange where they are making the trade. The contract is between each party and the exchange’s clearinghouse. In other words, when a buyer enters a trade, he enters a contract with the clearinghouse, so the exchange is on the other side of the trade until a seller comes along to take up the position — and the seller, in turn, enters a contract with the clearinghouse.
Flexibility of Contract
Futures contracts are standardized, with the terms of each contract fully specified. Generally, a futures contract specifies the following:
- The quantity of the asset that constitutes a single contract
- How the asset is measured
- The grade or quality of the asset — the octane number of gasoline, for example, or the karat of gold
- How the contract will be settled — cash settlement or physical delivery
- The currency in which the contract is quoted and the minimum unit of denomination
Forward contracts, on the other hand, are easily customizable since the parties are dealing directly with themselves. They can even alter the terms of their contract along the line.
Futures trading is well regulated, with rules guiding the process of trade entry, trade closure, rollover, and settlement on expiration. Traders are required to have a specified minimum amount before they can enter trades, and all through the life of a trade, the trader must maintain a certain minimum balance (maintenance margin). Furthermore, futures contracts are marked-to-market daily — meaning that daily imbalances are settled each day until the contract expires — and the final settlement is done over a range of dates.
On the other hand, because they trade over the counter, forward contracts are not regulated. Each party is left to find ways to protect his interest.
Since the exchanges, through their clearinghouses, are the counterparty to the trades in a futures market, futures contracts carry little or no risk of counterparty default. At the expiration of a contract, the exchange makes sure the contract is settled according to the terms of the contract, either with cash or by physical delivery.
A forward contract, on the other hand, has a high risk of either party pulling out of the contract. For instance, in a crude oil contract, the seller may not honor the deal if oil price at the time of delivery is much higher than the negotiated price, while the buyer may pull out of the deal if the price at the time of delivery is much lower than the negotiated price.
Open Outcry trading vs. Electronic Trading
Before the advent of electronic exchanges, where computers are used to match orders, futures exchanges relied on pit trading, or “open outcry trading”. Let’s discover what “open outcry trading” and “electronic trading” work.
Open Outcry (Pit Trading)
Open outcry, also called pit trading, is the old method of trading futures, whereby traders in the trading pits use verbal and hand signals to communicate orders to one another. A trading pit is the part of the trading floor where trading is conducted.
When a customer sends an order to a broker, the broker sends it to the trading floor of the futures exchange for that particular contract through an order clerk. The clerk relays the order to a floor broker who then makes the trade by communicating the order to other traders by shouting the order or using a hand signal. After the order is executed, the floor broker transmits the details to the clerk, and the clerk relays it to the receiving broker for documentation.
Because of the many steps involved in the process, the open outcry system takes some time to execute a trade order. Although the system has been replaced with electronic trading in several places, it is still popular in some exchanges in the US, where it is used together with electronic trading.
In this method of trading, sophisticated computers programs are used to match buy and sell orders for instant execution. Limit and stop orders are also queued in, awaiting execution when the price gets to their levels. The sell order with the lowest price assumes the current ask price while the buy order with the highest price becomes the current bid price. The difference between the ask and bid prices is known as the spread.
Advantages of Electronic Trading
Electronic trading has many advantages over the open outcry method, and here are some of them:
Faster execution: For electronic trading, trades are executed in seconds or milliseconds.
Less cost: The cost of trading is significantly reduced in electronic trading when compared to the open outcry method.
Convenience: Traders find electronic trading more convenient, as they can place and monitor their trades from the comfort of their homes.
Greater volume: With the availability of electronic trading, more retail traders have access to the market, thus, increasing the volume of trades.
Advantages of Pit Trading
However, pit trading also holds some advantages, which all stem from the fact that it’s a gathering of people that mirrors the sentiment of the market:
- Pit trading makes it possible for traders to see each other and determine the level of fear and greed in the pit. An experienced trader could then use this information to better his edge in the market.
- The noise level could help pit traders determine how volatile the market is
Now that we’ve covered nearly all information on futures markets we wanted to include, let’s have a look a very adjacent topic, namely clearinghouses. They play a very important role and support the futures exchanges and their operations!
The Role of Clearinghouses
In the futures market, the clearinghouse is the department whose main function is to make sure that both parties in a contract — the buyer and seller — honor their obligations. The clearinghouse functions as a middleman between a buyer and seller in order to see to it that every part of the transaction, from contract opening to settlement, runs smoothly.
Every exchange has a clearinghouse that takes care of the trades on the exchange. While some exchanges — for example, CME Group, ICE, and Eurex — have their own in-house clearinghouses, others contract a clearing firm to handle the trades on their exchanges. Nasdaq Futures Exchange, and Cboe Futures Exchange, for example, use the services of the Options Clearing Corporation(OCC), a derivative clearinghouse that services over 16 exchanges.
The main roles of a clearinghouse include:
- Counterparty guaranty
- Daily settlement
- Supervision of asset delivery on contract expiration
- Contract performance oversight
The clearinghouse ensures that when a seller puts in a sell order, the order is executed promptly. It does that by assuming the counterparty position — it buys the seller’s contract and selling it to the buyer. So the clearinghouse acts as a counterparty for every trade placed on the exchange, thereby ensuring the execution of those trades.
Another important role of the clearinghouse is to ensure that the traders’ accounts are marked to market at the close of each trading day, settling all the changes in the accounts. Accounts that require additional margin are informed to post the margin before a particular time on the next business day.
Supervision of Asset Delivery on Contract Expiration
If a contract is to be settled by physical delivery, it is also the job of the clearinghouse to supervise the delivery of the underlying asset when the contract expires. The clearinghouse ensures that the seller delivers the asset to the buyer and that the buyer completes the payment and takes delivery of the asset.
Contract Performance Oversight
The clearinghouse also monitors all the contracts, from when they’re opened to when they’re liquidated either before expiration (closed out by the corresponding parties) or at expiration (settled). It takes the trading data and reports them accordingly.
Open interest: What is it?
Also known as open commitments, open interest is the total number of outstanding contracts that are open and actively trading on an exchange. It represents open contracts that have neither been closed out by the corresponding parties nor settled at expiration.
For a contract to be opened, there must be a seller of the contract and a corresponding buyer or vice versa, and from the moment the seller or buyer opens the contract, that contract is considered open until it is settled at expiration or the traders in the contract close it out by taking the opposite of their initial positions. So open interest is the totality of open buy or sell contracts and not the total of buy and sell orders.
Unlike the equity market where the total number of outstanding shares of a stock to be traded is fixed, in the futures market, the number of contracts that are open for trading can change each day since new contracts can be created whenever a new set of traders (a buyer and seller) open a trade (new contract), and existing contracts can be liquidated through expiration settlement or when an existing set of traders close out their positions.
In other words, in the futures market, if a new buyer buys a contract from a new seller (or an already existing seller who wishes to increase his position), a new contract is created, and the open interest will increase.
On the other hand, when an existing buyer sells a contract to an existing seller (both parties are closing out their position), the contract is liquidated, and the open interest will decrease. Then, if an existing buyer sells his position to a new buyer or an existing seller buys from a new seller, the existing trader has simply passed of his position — no contract has been created or liquidated, and the open interest remains unchanged.
How Open Interest Differs From Trading Volume
Although some people confuse open interest with trading volume, they actually mean different things. To understand the difference between the two, let’s make give a practical example:
On August 23rd, trader A, who already holds 20 contracts (an existing buyer), sells his 20 contracts to trader B, who is just entering the market (new buyer). In this transaction, the 20 contracts were simply passed off to trader B, so new contracts aren’t created. The open interest will remain the same, but the trading volume for the day increases by 20 contracts.
What Does Open Interest Tell You?
Open interest tells you the way money is flowing in the futures market. It shows whether more money is coming into the market or money is flowing out of the market. When the open interest is increasing, it indicates that new money is flowing into the market, and when the open interest is decreasing, money is flowing out of the market.
Open interest may be used to gauge the momentum of an existing price trend in the underlying asset since a rising open interest can indicate an increasing interest in the asset with extra money flow into the market. So if there is a rising trend in S&P 500 Index in the stock market and the open interest in S&P 500 futures is increasing, the trend is more likely to continue as more money is flowing into the market.
Similarly, in a downward trend, if the open interest is rising, the price decline may likely continue. Other the other hand, if the open interest is declining when there’s an upward or downward price trend, the trend may be coming to an end. However, an increase or decrease in open interest does not, on its own, tell anything about the direction of future price movements.
Types of Futures Market
Whether it is corn, wheat, crude oil, DJIA, or 10-year U.S. Treasury Note, there is a futures market for any type of asset. Although it all started as a way for farmers to secure the sale of their produce before harvest, futures trading has since gone beyond agricultural produce to now include other asset classes, such as energy, metals, equity, interest rates, and foreign exchange.
These are futures contracts in which the underlying asset is either agricultural produce, agro-based product, or livestock. With about 17% market share, agriculture-linked futures contracts are the second largest in the commodity futures sector, after energy futures. They are mostly traded on the CME, though, other exchanges do offer agriculture futures to some extent.
Agriculture futures can be grouped into:
Grain futures include:
- Corn futures
- Soybean futures
- Wheat futures
- Livestock futures include:
- Cattle futures
- Pork futures
While forestry futures include rubber futures and cotton futures.
Farmers come to the futures market to secure reasonable prices for their farm produce so as to protect them against future price fluctuations. At the same time, companies that use agricultural products as raw materials and some big retail distributors use the market to ensure a constant supply of the products. However, some traders in the agriculture futures market are there solely for speculation.
An energy futures contract represents an agreement for the future delivery of an energy-related product at an agreed price. In other words, it is a type of futures contract in which the underlying asset is an energy product. The asset may or may not be physically delivered on the set date, depending on the terms of the contract.
The common energy products that are traded on the futures market include:
- Crude oil
- Heating oil
- Natural gas
These products are the most commonly traded commodities in the commodity futures sector. The ICE is a major marketplace for these futures contracts, and the same is true for NYMEX of the CME Group.
Producers of those energy products come to the futures market to secure acceptable prices for their products, while the major users (countries and companies) use the contracts to secure an adequate supply of the products at reasonable prices. There are also speculators that trade the contracts for financial benefits alone.
For this type of futures, the underlying commodities are metals. Here, a contract between a buyer and a seller is for the delivery of a specified quantity of the metal involved at a future date.
Some of the popular futures contracts under this group include
Precious metals like:
Base metals like:
And alloys like steel futures.
COMEX and the London Metal Exchange are some of the major marketplaces for metal futures.
These contracts are very popular for speculative purposes, as traders seek more opportunities to make money. The contracts are also useful in protecting miners and producers against volatility in price and help the users to secure a steady supply of the products at reasonable prices.
Also known foreign exchange futures, currency futures are those futures contracts in which foreign exchange rates are the underlying assets. With more than $5 trillion traded on a daily basis, forex is the biggest market in the world, and foreign exchange futures constitute a major part of the volume traded each day.
The forex futures market, just like other futures markets, attract speculators. In fact, the speculators help to maintain adequate liquidity in the market. Apart from speculation, companies use currency futures to hedge against large fluctuations in the foreign exchange market. For instance, if a European firm is expecting a large sum in U.S. dollars in the next nine months, it may buy a futures contract to hedge against any deterioration in the U.S. dollar.
EUR/USD futures is one of the most traded contracts in this market. Other popular pairs include:
These pairs involve the currencies of the major economies in the world.
Interest rate futures contracts are futures contracts in which the underlying asset is a security that pays interest. An interest rate futures contract represents a contract between a buyer and a seller for the future delivery of an interest-paying asset, but the parties involved can lock in the price of the asset at the present.
Common interest-bearing assets, which serve as the underlying security in this type of futures include Treasury bills (like the Treasury bill futures on the CME) and Treasury bonds (Treasury bond futures on the CBOT). Other common securities are:
- Treasury notes
- Certificate of deposits
- Corporate bonds
- Rate swaps
- Bond market indexes like the Barclays Index, and foreign governments’ bonds like the German bonds.
Just like other types of futures, interest rate futures are used for speculation and hedging, as changes in interest rates will normally affect those assets. Some of the most highly traded interest rate futures include:
- two-year Treasury futures
- five-year Treasury futures
- 10-year Treasury futures
- 30-year Treasury futures
10-year German bond futures is also very popular, as well as the Eurodollar.
Equity futures contracts gained entry into the futures market in the 1970s, and have in recent years expanded quickly as equity investors look for ways to hedge against market volatility and speculators look for more speculative opportunities. With the introduction of the E-mini S&P and other mini-contracts, traders with small accounts have the benefit of trading with a small margin. Another important benefit is that equity futures trade almost round the clock, so they can provide a window on the overall direction of the capital market.
This type of futures often has, as its underlying asset, an equity index. Some equity indexes that are tracked by futures are:
- S&P 500 Index
- DJIA, NASDAQ 100 Index
- Russell 2000 Index
- DAX 30 Index
- FTSE 100 Index
- Euro Stoxx 50 Index
- Nikkei 225 Index
- India’s Nifty 50 Index
The S&P 500 Index futures, FTSE 100 Index futures, Nasdaq-100 Index futures, E-mini S&P, and Nikkei 225 Index futures are some of the most traded equity futures in the world.
Aside from the equity indices, there are futures contracts on some of the most highly liquid individual stocks. These type of futures are called single-stock futures, and examples include Amazon, Apple, Goldman Sachs, IBM, and Google.
The Five biggest Futures Markets
There are billions of futures contracts traded in different parts of the world every year. The majority of these contracts trade in the five biggest exchanges in the world. These five exchanges are located in North America, Southern Asia, and Europe, and they include:
- The CME Group
- National Stock Exchange of India
- Intercontinental Exchange
- The Cboe Global Markets
- The Eurex Exchange
The CME Group
With billions of contracts traded each year, the CME Group is easily the biggest futures market in the world. The group is made up of the Chicago Mercantile Exchange (formerly Chicago Butter and Egg Board), Chicago Board of Trade (CBOT), Commodity Exchange Inc. (COMEX), New York Mercantile Exchange (NYMEX), Kansas City Board of Trade (KCBT), and the NEX Group.
The CME Group was created in 2007 by the merger between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade. It would later acquire the NYMEX Holdings — the holding company of the COMEX and NYMEX — in 2008, and again in 2012, it bought the KCBT, which deals majorly on hard-red winter wheat. The NEX Group was acquired in 2018.
With its headquarters in Chicago, the group has several offices in the major cities around the world, including London, Washington, New York, Houston, Tokyo, Sao Paulo, Alberta, Beijing, Sydney, and Hong Kong. Through its Globex electronic trading platform, the CME Group gives traders access to the futures market nearly 24 hours a day.
The group, through its many subsidiary exchanges, offer a wide range of products across many asset classes, such as equity index futures, interest rate futures, energy futures, metal futures, currency futures, and agricultural produce futures. The metal futures mostly trade at the COMEX market, the agricultural produce futures trade at the CME, while its energy futures trade mostly at the NYMEX.
National Stock Exchange of India
Incorporated in 1992, the National Stock Exchange of India (NSE) is the biggest financial market in India and the biggest futures market in Asia. It started off as a stock market, but it later introduced futures exchange and trades huge volumes of futures contracts each year. The exchange has its headquarters in Mumbai, the biggest commercial city in India.
Trading started on the NSE in 1994 when equity and debt securities were listed on the exchange. But futures contracts wouldn’t start trading on the exchange until the 12th of June 2000 when the Nifty 50 index futures contract was launched on the exchange. Nifty 50 index is a broad market index that tracks the 50 most capitalized stocks on the NSE.
The NSE futures market grew very fast, and in 2011, futures contracts on the U.S. S&P 500 Index and Dow Jones Industrial Average (DJIA) were introduced on the futures exchange. A few years later, futures on the U.K. FTSE 100 and the Japanese Nikkei 225 were also introduced.
Apart from the index futures, other futures contracts, such as interest rate futures, currency futures, and single stock futures are also traded on the NSE futures exchange. In addition, bullion and energy futures started trading on the NSE futures exchange in 2018.
Backed by some of the biggest players in the energy industry, Jeffery Sprecher established the Intercontinental Exchange (ICE) in May 2000 to offer an efficient and transparent electronic trading platform for energy commodities. The company is based in the US, but through acquisitions, it has expanded to different parts of the world.
In 2001, it acquired the London-based International Petroleum Exchange (IPE) — the leading open-outcry energy futures in Europe. From 2003, the ICE partnered with the Chicago Climate Exchange to host its electronic platform, and since 2005, all of its energy futures became fully electronic.
The ICE acquired the New York Board of Trade (NYBOT) and ChemConnect in 2005, Winnipeg Commodity Exchange (WCE) in 2007, Creditex in 2008, European Climate Exchange in 2010, and the NYSE Euronext in 2013. Through the acquisition of the NYSE Euronext, the ICE gained ownership of the London International Financial Futures Exchange (LIFFE).
In 2008, ICE partnered with Canada’s TSX Groups Natural Gas Exchange, extending their services to clearing and settlement of physical OTC natural gas contracts. Presently, ICE operates more than 23 regulated exchanges and six clearinghouses in different parts of the world.
The ICE started with energy futures, but with its acquisition of several exchanges around the world, the ICE now offers many other futures contracts, such as equity index futures, foreign exchange futures, agricultural product futures, and interest rate futures. However, energy futures remains the most popular product on the ICE market.
The Cboe Global Markets
Previously known as CBOE Holdings, the Cboe Global Markets consists of the Chicago Board of Options Exchange (CBOE), BATS Global Markets, and the Cboe Futures Exchange (CFE). Through the CFE and the BATS Global Markets, this company offers a wide range of assets to traders all over North America and Europe, including the popular volatility index products.
The CFE offers an all-electronic trading service that operates the open access market model with its dedicated market makers and market participants providing the necessary liquidity. Trading started on the futures exchange in 2004.
The majority of the futures contracts on the exchange are based on volatility indexes, with the VIX Index (the volatility index of the S&P 500 Index) being the most popular one. Other volatility indexes available on the exchange include:
- Volatility indexes on other U.S. equity indexes, such as the NASDAQ-100 Volatility Index (VXN), DJIA Volatility Index (VXD), and Russell 2000 Volatility Index (RVX)
- Volatility indexes on Non-U.S. equity ETFs, such as the EFA ETF Volatility Index (VXEFA)
- Volatility indexes on interest rates, such as the 10-year U.S. Treasury Note Volatility Index (TYVIX).
- Volatility indexes on commodity-related ETFs, such as Gold ETF Volatility Index (GVZ)
- Volatility indexes on single stocks, such as Equity VIX on Amazon (VXAZN)
All trades on the Cboe Futures Exchange are settled by the Options Clearing Corporation (OCC), the clearinghouse for the CBOE.
The Eurex Exchange
The Eurex Exchange, often called the Eurex, is a Europe-based futures market that offers futures contracts on several European products. Being a subsidiary of Deutsche Borse AG, it is headquartered in Eschborn, near Frankfurt am Main in Germany. The Eurex Exchange is the biggest futures and options exchange in Europe, and trading on its marketplace is fully electronic.
In fact, the Eurex was created to replace the trading pit and open outcry system in the Deutsche Borse. The Deutsche Borse AG partnered with the SIX Swiss Exchange in 1998 to develop an electronic trading system, and this gave rise to what is now known as the Eurex. But in 2012, the Deutsche Borse AG acquired all of SIX’s shares in the Eurex and became the sole owner of the exchange.
Euro Stoxx 50 Index futures and DAX 30 Index futures are some of the most popular futures contracts that trade on this marketplace. Other popular contracts on the exchange include German bond futures, Swiss bond futures, foreign exchange futures, and commodity futures.
In addition to the trading platform, the exchange also provides contract clearing and settlement services via the Eurex Clearing, which takes care of the settlement of contracts on expiry and serves as a central counterparty for trades on the platform.
The futures market is where farmers, corporations, and fund managers can hedge their businesses and investments against fluctuations in the prices of their assets. It offers better protection to them because the market is standardized and the risk of counterparty defaults is low. Speculators also use the futures market to look for more money-making opportunities.
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