what are futures contracts in forex trading?

Investors use forex futures contracts to manage exchange rate uncertainty and risk, by locking in todays exchange rate for use tomorrow.

Futures don't apply to currency pairs alone, they can also be used for commodities, equity, etc.

A futures contract will guarantee that even if prices change tomorrow, you still get to buy/sell at the old price specified in the futures contract. Futures are standardized contracts and trade legally on exchanges.

Futures are a financial contract between two parties on the terms that one will buy a specific amount of an underlying asset, for a specific price & at a specific future date; from the other party.

Futures are no joke, cos they are legally binding and trade like normal securities on various exchanges.

Futures contracts usually have a lifespan of 3 months and they are known to expire on the 3rd Friday of every month. When they expire, they can cause sudden volatility in the market and some call the expiry hour the "witching hour" because of the sudden volatility that may occur.

Futures contracts expiring on Fridays is one reason why they say Friday is a bad day to trade forex

Futures are basically an agreement to buy something tomorrow, but at today's price. This "agreement" is traded on exchanges like the Chicago Mercantile Exchange (CME) etc. Futures are mostly cash settled so no physical exchange of the underlying commodity ever takes place.

Futures also have an expiry date, and you can sell the contract or enter into an offsetting one before its expiry.

Futures are high risk instruments because they are marked to market at the close of every business day and you are debited/credited for the change in price of the underlying.

To manage the risk of Futures contracts, investors buy options on the futures contract which is a way of hedging. The options give the investor the right but not the obligation to buy/sell off the futures contract if they see it is not going to end in the money.

If the investor chooses not to execute the options contract, he is free to walk away but he will lose the premium he paid to buy the options.

Investors only buy options when they are afraid their futures contract may not end in the money, so when we see many options being bought it means there is fear in the market.

The Volatility Index is based on measuring this fear, by measuring how many S&P500 options are being bought.

Futures Definition

Futures are a legal contract between you and an exchange to buy/sell a precise quantity, of a specific underlying asset (such as crude oil, currencies, grains etc.), at a precise date, to be delivered to a precise location.

Risk Profile of Futures

In futures contracts, because you are buying from and selling to an exchange, the counterparty risk is eliminated because you are dealing directly with an exchange and not a random person on the street.

Contract Specifications

Futures contracts are standardized & traded every day on an exchange so you they are very liquid and if you want to get out of one, you can easily sell it to someone else.

The exchange is responsible for determining what quantity of the underlying asset will be contained in one contract. Most crude oil futures contracts are standardized for 1,000 barrels of oil per contract.

The exchange is also responsible for specifying where the underlying will be delivered to, and when the delivery date is near; trading stops for that specific contract.

Some exchanges even allow you enter into mini contracts for a lesser quantity of the underlying asset, and this is to make it affordable to most investors. This is why we have things like the e-mini-S&P 500 contract.

Contract Nomenclature

Contract Nomenclature

Futures contracts always have a certain nomenclature when they are listed on an exchange. The nomenclature is unique to every exchange & usually contains a code for the type of underlying asset, followed by an alphabet for the month of expiry and another number for the year of expiry.

If you see a contract with this nomenclature: ESH6, this is what it means

ES= S&P 500 e-mini

H= Expires in the month of March

6 = Expires in the year 2026

If you see a gold future displayed with the code GCZ5 it means:

GC = gold contract

Z = expires in the month of December

5 = expires in the year 2025

What Happens When Futures Expire?

1. Physical Delivery

After a futures contract expires, you can choose to move for the settlement & physical delivery of the underlying asset.

2. Cash Settlement

Instead of receiving or delivering physical goods, you can opt to pay or receive the cash equivalent.

3. Contract Extension

You can opt to extend the contract by rolling it over.

Futures Pricing & Cost:

Futures trade on exchanges every day so the price will be displayed, and the price also fluctuates according to market forces.

You can click on any futures to see the contract specs. In the image attached, we see a Platinum Futures (PLV5) trading at a current market price of $1,359.

However, from the contract specs we see that each PLV5 contract contains 50 troy ounces of platinum so the notional value of the contract will be ($1,359 x 50 ounces) = $67,950

When you buy and hold a futures contract overnight, it will be marked-to-market meaning you will be debited if the final daily settlement price is lower than your entry price.

You will also be credited if the final daily settlement price is higher than your entry price.