3. Futures Terminology

Futures in Contemporary Markets

While futures were originally used for the physical settlement of traded commodities, they are now a widely used derivative product in almost every area of the contemporary markets.

The market for futures and options (another form of derivatives contract) are occasionally many times larger by value than the market for the actual physical delivery of the underlying asset.

For example, the market for oil futures has been 30 times larger than the market for the physical delivery of oil on some days.

They are used for both speculation and hedging, as interested parties can make trades based on the future direction of prices.

Speculators use futures to trade in areas of the markets that they may otherwise have no access to. The trading of physical oil or large amounts of gold, as examples, is generally limited to a small number of institutions, whereas most retail traders have access to futures trading.

The option for cash settlement means that investors without storage capacity can make trades in most commodities, and that intangible objects, such as the VIX index, can be traded easily and securely. Futures with a physical delivery option, however, can carry added costs for the physical storage of the underlying asset.

Most futures are traded on margin, which allows speculators to make leveraged trades in markets where they may otherwise be unable to.

Most hedging using futures, by contrast, is not intended as a wager on the direction of the price as speculation, but rather as a form of insurance in the case of undesirable changes in price.

This can include both directional changes and an increase in the overall volatility of the price. They allow related producers to hedge their profits as they are affected by the underlying asset, which can be both to cover against profit reductions or to smooth the flow of profit between different periods of time.

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