The post How are Futures Prices Determined? by Stjepan Kalinic appeared first on Benzinga. Visit Benzinga to get more great content like this.
Did you know most of our readers prefer to trade futures through Interactive Brokers or Plus500?
Futures contracts have traded hands in the Chicago Mercantile Exchange (CME) since the late 1800s when the exchange was known as the Chicago Produce Exchange. Since these humble beginnings, futures contracts have become a popular way for investors to get leveraged exposure to assets. These derivatives allow investors to lock in prices for assets and are frequently used for commodities. This guide will explore what goes into determining the prices of futures contracts.
Table of contents [Show]
What are Futures Prices?
Futures are derivative financial contracts tied to an underlying asset. They bound the parties to transact the asset at a predetermined future date and price, regardless of the spot market price at the expiration date.
Futures were a highly beneficial invention for all the parties:
- Suppliers: Having a demand guarantee for the product before committing to production
- Dealers: Locking the cost structure months in advance
- Traders: Engaging in lucrative transactions based on informed speculation
Originally futures were tied to agricultural commodities like rice, corn or cotton. Currently, the most liquid futures are 10-year government bonds, ES (S&P 500) and crude oil futures.
Nowadays, futures are often used to hedge the risk of unfavorable price movements — particularly useful for those who have to hold the underlying asset on their books.
Although they might seem similar, you have to understand the significant difference between futures and options. A futures contract is a buyer’s obligation to buy an asset (when held at expiry) and the seller’s obligation to deliver that asset at a specific future date. So, options are not binding the buyer to the transaction but allow facilitating the transaction if wanted.
Examples of Futures Prices
Understanding futures prices is the easiest through a historical example.
During the pandemic, NYMEX WTI crude oil futures went as low as -$36.98 per barrel. For the first time in history, oil owners would pay you to take it off their hands.
There are three things you have to know to understand why:
- Supply: Due to OPEC disagreement, there was no further restriction on global production
- Demand: Diminishing due to a global pandemic
- Storage and delivery: Finite capacity in Cushing, Oklahoma
While the world was heading into the pandemic, the oil demand collapsed due to a lack of business activity. Yet, OPEC couldn’t reach a new agreement and there was no restriction on supply.
Meanwhile, storage facilities were running out of space. All of the NYMEX West Texas Intermediate (WTI) contract was delivered at Cushing.
On Friday, April 17, 4 days before the settlement date, open interest was 108,593 contracts representing 108,593,000 barrels for the May delivery. Yet, the remaining available capacity at Cushing was around 17,300,000 barrels.
With just two trading days left, speculators held six times more oil (delivering in 1 month) than there was available storage at the present moment! The only way to avoid the delivery was to close the contract, effectively taking a counterbalance short position. However, that would imply finding a buyer — and those were few and far between.
Holding a buy contract became a quintessential financial hot potato, and the negative settlement represented the price the speculators were paying to have that barrel of oil stay in the ground. After the dust settled, open interest stood at 13,044 contracts — low enough for available storage capacity. The price returned to positive territory.
Formulas for Calculating Future Prices
Futures prices depend on the spot price of the underlying asset, adjusted for time and dividend accrued till the contract expiry.
How are futures prices determined?
Futures price = Spot price x (1 – rt) – d
- rt = the risk-free rate, like the government treasury
- d = dividend
By scaling the risk-free rate proportionately, you arrive at a more generic formula:
Futures price = Spot price x [ 1 + rt x (x/365) – d]
- x = number of days to expiry
By using this formula, you will arrive at the fair value price of the future. Yet, this doesn’t guarantee that price on the market. The price may deviate from fair value due to supply or demand and other factors.
Benefits of Forecasting
Futures prices reflect market expectations. Forecasting those expectations opens up both hedging and speculative possibilities, especially when discovering deviations from fair value. Although a large deviation might result in an arbitrage opportunity, remember — the market can stay irrational longer than you can stay solvent!
Best Future Markets to Trade
There are three key attributes to look for when deciding what futures market to trade:
- Contract size (margin): Futures margins are lower than equities day-trading requirements. Contracts can be in standard, e-mini or even micro e-mini size, each holding a smaller dollar value. Micro-sized contracts can have margins as low as $50.
- Liquidity: Trading the highly liquid market is easier because your actions will have a smaller impact on price. This is particularly important in day trading.
- Volatility: The greater the volatility, the higher the opportunities to profit. Volatility impacts your risk-to-reward ratio, but choosing a volatile market ultimately depends on your strategy.
Based on these conditions, some of the best futures markets to trade are:
- S&P 500 E-Mini: This is the most liquid futures market in the world — a cost-efficient way to gain market exposure to the S&P 500.
- Crude oil: Hedgers and speculators both trade contracts in this volatile asset. More than a million contracts exchange hands each day.
- 10-year T-Notes: U.S. Government bonds are the most sought-after fixed-income securities in the world. There is (almost) never a shortage of market participants that need to hedge their exposure to U.S. debt, providing for an extremely liquid market.
Best Online Futures Brokers
You will need a broker account to trade the futures. Check our overview of the best online futures brokers in the table below. You can also check our guide on how to trade futures.
Claim Exclusive Offers
EdgeClear is a fast-rising, forward-thinking online broker specializing in futures trading. Futures trading can offer profitable opportunities if you’re seeking a fast-moving investment opportunity. However, futures are complex instruments and futures trading is risky — it is a highly leveraged form of speculation. EdgeClear aims to simplify the process by offering a practical solution that blends innovative technology with efficient customer service without sacrificing cost.
EdgeClear’s mission is to redefine the trading experience by providing exceptional customer service, robust technology, and a personal touch. They are committed to empowering their clients, from entry-level traders to seasoned professionals, with tools and support that enhance their trading journey. Their focus is to be a catalyst for success, offering a platform where expertise meets innovation in the trading world. This helps sustainability in your futures trading journey.
EdgeClear offers one of the most competitive commissions and fees compared to other future brokers. Its proprietary trading platform, EdgeProX, offers an all in one solution for the active trader. EdgeClear is led by highly knowledgeable industry experts with a comprehensive understanding of the complexity of futures trading from clearing to execution.
These experts are committed to meeting your toughest trading challenges and requirements through a combination of vast technical and practical trading experience. Benzinga spotlights EdgeClear, providing a constructive review of its features and services to help you decide if it’s the ideal futures broker for your trading journey.
- Experienced futures traders seeking robust and innovative futures trading platforms and technology to optimize their futures trading goals
- Futures traders (individual and institutional), Commodity Trading Advisors (CTAs), Commodity Pool Operators (CPOs), futures funding entities and other institutional clients seeking algorithmic trade execution
- Individual active online futures traders (both professional and independent) seeking robust trading technological infrastructure for direct market access
- Beginner futures traders or investors seeking accessible, low-cost and user-friendly futures brokers to kickstart their futures trading journey
- Those looking to advance their understanding of the futures market and trading setup via adequate educational resources that provide an inside look at common trading processes, struggles, successes and lessons
- Competitive and affordable futures commission rates and fees
- Beginner-friendly and feature-rich proprietary trading platform — EdgeProX
- Unparalleled customer service, evident from customer reviews across independent platforms like Trustpilot and Google Reviews
- Customers will receive a personal EdgeClear broker assigned to their account for all their trading needs
- Flexible account options, including IRA futures, account for tax-efficient retirement investing in futures and managed futures accounts
- Excellent educational and learning resources, including podcast and YouTube videos and Knowledge Base (Support Center)
- Demos or simulation accounts to help you try out strategies before signing up to a live account
- Multiple futures products across various asset classes and exchanges
- Currently only supports futures trading
NinjaTrader is a powerful derivatives trading platform specializing in futures, forex and options. The platform has a number of unique trading tools. A free version does exist without the extra goodies provided by Trader + and OrderFlow + but users can still break down charts, backtest strategies and trade without upfront payment. NinjaTrader hosts its own brokerage services but users have their choice of several different brokerage options. Accounts have minimums depending on the securities traded and commissions vary depending on the version of the platform. Advanced derivatives traders will have endless fun with the platform’s mighty array of tools and analyzers.
The free version, which is included with all brokerage accounts is a great starting platform for new traders without the financial commitment. As you grow in your trading and are ready for more tools and functionality, you can add more complexity.
- Futures Traders
- Traders looking for 24/7 action
- Advanced Traders
- Powerful analysis tools
- Free download and simulated trading
- Open source trading apps to enhance experience
- Can only trade derivatives like futures and options
Interactive Brokers is a comprehensive trading platform that gives you access to a massive range of securities at affordable prices. You can buy assets from all around the world from the comfort of your home or office with access to over 150 global markets. Options, futures, forex and fund trading are also available, and most traders won’t pay a commission on any purchase or sale.
IBKR is geared primarily toward experienced traders and investors but now with the availability of free trades with IBKR Lite, casual traders can also acclimate to IBKR’s offerings.
- Futures traders
- Trading futures 24/7
- Sophisticated investors
- Access to international markets
- Buy & sell futures at lowest commission rates
- Hedge positions or act on price movements in 150 financial markets worldwide
- Trade futures side by side on a single screen w/ substitute asset classes in stocks, bonds, options
- Beginner investors might prefer a broker that offers a bit more hand-holding and educational resources
Optimus Futures is a leading discount futures broker offering highly customized trading solutions geared towards cost-conscious retail traders with an eye for technology and personal service. Customers gain access to premium tools at no additional cost such as depth-of-market surface, footprint charting, and real-time news alerts along with a fully integrated trading journal.
Users can register a trial version of their software to take a test-drive of the platform, unlocking many of the analysis and charting features including unlimited simulated trades. Traders can also leverage Optimus Futures 3rd party app integration, allowing you to choose the futures trading platform best suited for you.
- Futures & micro futures traders
- Low account minimums, commissions, and margins
- Beginner futures traders
- Unlimited simulated trading
- Low day trading margins
- Highly experienced and competent technical support
- Customizable data fees and order clearing
- Limited to derivatives trading like futures
- The selection of data feeds and clearing firms can be overwhelming for newer traders
For you with an interest in online courses, check our outlook of the best futures trading courses.
Getting Started with Futures
Whether your goal is to hedge or to speculate — futures present a cost-effective way to gain leveraged exposure in some of the largest markets in the world. Yet this does not come without dangers. Given the leverage and volatility, the losses incurred on the futures market can be soul-crushing. As traders witnessed in April 2020, futures can have a negative price.
No matter what your goal is, always thoroughly study the asset before you trade it and use a risk management strategy.
Frequently Asked Questions
Do futures prices predict spot prices?
Not always. Futures forecasting will depend on whether the commodity is non-storable, storable with a large inventory or storable with a modest inventory. For example, non-storable commodities like eggs will not impact the spot price because they cannot be taken out of the market for future use.
Why are futures prices higher than spot prices?
This is due to the costs of carry — generally involving all the expenses that an investor foregoes over a period of the contract. Examples are physical storage, insurance or spoilage.
Futures prices are generally higher than spot prices, but as seen in the WTI crude oil example, it is not always the case.
What is the difference between the spot price and the futures price?
The difference is in the delivery date. A spot price is a price for immediate delivery of the commodity (on the spot). The futures price is the price quoted for delivery at a specified future date. The difference between the spot and futures price is called the basis.
The post How are Futures Prices Determined? by Stjepan Kalinic appeared first on Benzinga. Visit Benzinga to get more great content like this.