How are Futures Prices Determined?

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.

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.

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