Trading techniques and basic terminology
Futures are securities that stand for futures contracts traded on a futures exchange. A futures contract is about the delivery of an asset to a certain place at a specified future date.
It means that at the moment you buy a contract the underlying asset is neither actually transferred nor paid for. Therefore the price of a futures contract at each particular moment of time reflects the current price of the asset plus interest for the time period before realisation of the contract, i.e. before settlement.
Futures contracts are highly standardised as to quantities, specifications and places and dates of delivery.
Because some underlying assets cannot be standardised futures contracts only exist for the most basic ones. Currently, these are: futures for agricultural commodities, metals, oil, stock indices, currencies, stocks, etc.
Futures markets are permanent auctions that reflect the latest data on the forces of supply and demand for a particular asset.
Futures are traded, for example on such major futures and options exchanges as Chicago Board of Trade, Chicago Mercantile Exchange and NYMEX. Through the intermediary of brokers like Rietumu Banka, investors place sell or buy orders for futures contracts trying to predict the direction of price fluctuations on the underlying assets and earn money by doing it.
It is worthy of note that the terms „sell” and „buy” on futures markets have rather a nominal meaning, because you do not have to first buy a contract in order to sell it. What is important is whether you go long or short.
Futures markets and security deposits
When two parties make a futures contract the buyer and the seller deposit a certain amount of funds to a security deposit to protect both parties from losses in case one of them refuses to fulfil the contract.
The size of the deposit depends on price volatility for the given type of contract and is established by brokers.
The minimum margin requirements (security deposit) on futures are established by futures exchanges where these contracts are traded. Normally, the margin would be about 5% of the market value of the futures contract.
Futures exchanges keep track of market trends and risks on ongoing basis and can raise or reduce margin requirements accordingly. Brokerage firms may set higher requirements for their clients than the ones established by futures exchanges.
Initial margin (initial margin requirement, sometimes also called original margin) — the amount an investor has to deposit to his brokerage firm’s account per each contract he buys or sells. Accumulated profit or loss will be added to or deducted from this amount on daily basis as long as you have an open position.
If as a result of losses the balance of your margin account falls below a margin call situation arises, i.e. your broker will ask you to deposit additional funds to your margin account to bring your margin up to the initial margin.
A similar situation might occur if the futures exchange or your broker raises margin requirements.
There are two types of market participants who deal with futures (as well as with options) — hedgers and speculators. Hedgers use futures as insurance against price fluctuations: as a rule, their main business is related to producing or using the underlying asset. Unlike hedgers speculators only buy and sell futures for profit from price fluctuations.
Types of contracts
There are two types of contracts: with physical delivery of the underlying asset and with cash settlement. Each contract specifies the delivery of the asset at a specified date of a specified month.
Please note that even if a contract provides for physical delivery of the underlying asset very few actually go that far. The truth is that speculators are not interested in the commodities they buy, their main goal is to get profit from price increase, therefore they prefer receiving the difference between the invested amount and the value of their futures on the final settlement date or before it in case they sell their contracts to someone else.
Remember that you can start your speculations either by buying a contract if you believe that the price is going to go up or by selling it if you think the price is going to drop. In any case profit or loss is the difference between the buy and sell price.
Futures in figures
So why is it that futures bring much higher profit or loss than other financial instruments? The thing is that when you buy a futures contract you do not pay the whole amount, what you actually pay is much less than that, because you use leverage. The high level of profit or loss is possible, because you invest a relatively small amount, which is called initial margin.
For example, if your initial margin is USD 1,000 you can buy or sell a USD 25,000 contract for delivery of soy beans. If the price goes your way you earn from the total value of the contract, i.e. USD 25,000 USD, but if it goes against your expectations you lose from USD 25,000. The higher the leverage the higher the profit or loss, therefore one may say that leverage is a two-edged sword and it wouldn’t be wise to forget it.
Consider the following example: let’s assume that you buy a futures contract for the S&P500 index when its value is USD 1,000.
The contract specifies that the value of one point of the index is USD 250, therefore the total face value of the contract is USD 250,000 (USD 250 multiplied by 1,000).
Let’s assume that your initial margin requirement is USD 20,000. The value of one point is USD 250, therefore if the value of the index changes by 1 point the contract value changes by USD 250. If the index grows from 1,000 to 1,020 points your profit is USD 5,000 (20 points multiplied by USD 250), if the index drops from 1,000 to 980 you lose USD 5,000.
I.e. you either earn or lose USD 5,000. Considering that your initial deposit was USD 20,000 your profit or loss is 25% of the deposit, while the value of the underlying index has only changed by 2%.
In other words, leverage (margin) leads to dramatic increase in interest income or dramatic increase in losses when compared to usual buy or sell deals with any type of assets. Therefore those who trade futures must be psychologically prepared to face high income or loss ratios.
It is one thing when the market falls and the value of your assets drops from USD 200 000 to USD 190 000, i.e. by 5%, and completely another thing when you lose half of your investments when the market falls by 5%.