The futures markets are also known as the derivatives markets. The name comes from the fact that the prices in the futures markets are derived out of the underlying asset. The price of this underlying asset is of course from the spot markets.
Although futures trading might seem and look similar to trading regular spot markets, there are some clear differences which traders need to know. Orbex.com offers futures trading in the oil markets as well a selection of indices such as the Dax, Nasdaq, Dow Jones, and the S&P500.
One might confuse futures markets to that of CFD’s (Contracts for difference) which is another derivative market. With so many variants of the same underlying, traders should pay attention to the markets they are trading.
Here are three things to know about the futures markets.
1. Futures markets have rollovers
Unlike the spot markets such as the WTI crude oil spot, the lot size, spread and even the collateral required to trade can vary when you switch to the oil futures. For example, while you can buy and hold your positions over months at a stretch on the spot crude oil markets, this is not possible with the futures oil markets.
This is due to the fact that the futures contracts come with specific expiry times. The expiry times or contract months vary based on the type of futures you are trading. Typically, commodity futures come with monthly expiries; for example, Gold or silver futures and WTI or Brent futures.
What this means for traders is that the contracts need to be rolled over before the expiry date. This means, having to close the current month’s contract and open new contracts in the forward months.
This, of course, incurs some costs as well as the spread between the current month and the forward month can differ.
2. Prices are derived from the spot markets
There are many types of futures contracts now available. Most commonly you can find that there are currency futures such as the E6 or EURUSD futures contracts. The prices for this are derived from the underlying EURUSD spot market.
Quite often, you can find some degree of variation in prices. In other words, the pricing you see on the EURUSD futures contract can differ slightly from the EURUSD spot prices. However, towards the end of the contract month, you can see that the futures prices tend to converge to the spot prices.
This occurs due to the law of supply and demand and the arbitrage opportunities that eventually balance out the markets.
An important take away for futures traders is that the futures price chart must be looked at independently. For example, a EURUSD spot price might close the day at $1.20, but the Euro futures contract can close higher or lower than the spot price.
The chart below shows an overlay of the euro futures prices on the right and the EURUSD spot prices on the left. You can see based on the overlay the difference in the pricing.
3. Futures are usually traded to hedge underlying exposure
For most speculators and intraday traders, the futures markets offer opportunity to speculate on the price movements and make money off it.
However, the futures markets are largely traded by financial institutions and corporations in order to hedge their exposure to the underlying markets.
This can work in different ways. For example, an airline company can trade futures and in fact take delivery of the underlying asset when it thinks that prices will increase in the future.
By trading futures, the airline company typically hedges their exposure to a price increase or volatility in the underlying oil markets. The same holds true with corporate as well that have to deal with foreign currency payments.
In order to avoid paying huge amounts in foreign currency due to the volatility in the currency markets, corporate can make use of the futures markets in order to get a better price on the exchange rates.
Despite speculators being only concerned to make a profit from the volatility in the futures markets, it is important to understand how the above markets work. The above three key things about the futures markets are just a basic overview of the larger context that determines the futures markets.