Futures might sound complicated, but strip out the jargon and they’re simply contracts that let you buy or sell an asset for a set price at a later date. So when it’s time to settle, you’re obliged to buy or sell the underlying asset at the agreed price regardless of its current price. That’s different from options, which let you buy and sell the underlying asset but without the obligation.
You can trade futures on a range of assets including commodities, stock indexes, currencies, precious metals, interest rates, and even cryptocurrencies. They’re fairly easy to trade too: the contracts are all standardized and trade on a futures exchange, so you can transfer or trade a futures contract as you would a stock, without fear of the other party defaulting. If you prefer contracts on customized or “one-of-a-kind” assets, you can also consider forward contracts. They work like futures but are privately negotiated between two parties and carry a much higher default risk.
Investors who trade in the futures market usually have one of two aims: to hedge the price of an asset by locking in a future price or to speculate on the price direction of an asset. The latter group – also known as “speculators” – seek to profit from the ups and downs of futures prices.
Here’s an example: traders who expect oil prices to be substantially lower in a year could sell a futures contract that obligates them to sell oil at today’s price one year from now. If their predictions are right, they would profit from the price difference between the contract’s price and the price of oil when the contract expires. But if they’re wrong, they’ll make a loss. Now, a refiner could take the opposite end of that traders’ contract: they’d choose to buy oil at a fixed price a year from now because they want to hedge their input cost, by lowering the risk that they’d later have to buy oil to refine at a higher price than today’s.
There are a few reasons to trade futures. For one, they can help diversify your portfolio. For another, they could potentially allow you to profit from your outlook on asset prices while providing a hedging benefit if you’re looking for price stability. Bear in mind, though, that hedging works both ways, so locking in the price now could also mean you lose out on favorable price movements. Plus in other jurisdictions like the US, you could benefit from tax advantages depending on the long and short-term capital gains tax rates.
And then there’s leverage: see, the upfront capital required for futures is often substantially lower than the contracted value – although your gain or loss is still calculated as if you’d deposited 100% of the contract. With leverage, you have the potential to magnify both your gains and losses.
Before you start trading futures, you should be familiar with a few key terms:
Expiration: While stocks can be held in perpetuity, futures contracts have an expiry date. Any position you hold is automatically closed once the contract expires.
Settlement: This is how you choose to pay or “settle” your contract. Usually, that’ll be with cash or by physical delivery of the asset, but your form of settlement will depend on your individual needs, the underlying asset, and your aims (to speculate or to hedge).
Price limits: To maintain an orderly market with lower price volatility, most exchanges set a limit on how much higher and lower futures contract prices can move in a day. The limits depend on the underlying asset: the more volatile the asset price, the higher the limits.
Mark-to-market: This is the process of calculating the current market value of your futures contract daily, rather than letting your profit or losses accumulate before settling when the contract expires. This way, all accounts between the involved parties are settled at the end of each day. And because that means losses can’t snowball, credit risk tends to be lower for futures.
Margin: When you trade futures, you only need to put down a small amount of money as collateral – your “initial margin”. That’s usually a percentage of the value of the futures contract, so you can trade a far bigger position than you otherwise could with a small deposit. But to keep holding your position, you need to make sure you have enough surplus funds, known as your “maintenance margin”. See, because the value of the future is adjusted daily, your deposit as a proportion of the overall value could drop below the required amount. If that happens, you might face a “margin call” that requires you to top up funds.
Let’s see how you might use futures to hedge portions of your investment portfolio.
You currently own foreign property in the US, and recently closed a deal to sell the estate for $1.25 million (USD).
At the current market rate of USD 1: EUR 0.6, you expect to receive €750,000 (EUR).
You think the dollar is likely to depreciate against the euro over the next three months. And because the lead-up to completion and exchange of contracts can sometimes take months, you don’t want to be exposed to currency risk in the meantime.
So to lock in today’s rates, you could purchase six future euro contracts (€125,000 per contract) at 0.6 EUR/USD with an expiration date of three months from now. This means you’re obligated to buy €750,000 for $1,250,000 when the contract expires.
At the time of settlement, if the US dollar depreciated to USD 1: EUR 0.5 as you expected, you’d have avoided €12,500 in potential currency losses. Here’s the maths:
$1.25 million x 0.5 = €625,000 (property value using FX at time of settlement)
€750,000 (the amount hedged in the futures contract) – €625,000 = €12,500
On the other hand, if the US dollar had appreciated hitting USD 1: EUR 0.7, you’d have lost out on €12,500 in potential currency gains.
$1.25 million x 0.7 = €875,000 (property value using FX at time of settlement )
€750,000 (the amount hedged in the futures contract) – €875,000 = –€12,500
The price of a futures contract depends on factors like interest rates, time until expiration, storage costs, and the price and volatility of the underlying asset. And as always, the type of investor you are dictates the risks you take on.
If you’re purely speculating about the price of an asset, you risk taking a loss if prices move against your expectations. But if you’re using futures to hedge, your loss is limited to missing out on potential gains.
The more leverage used, the higher the risks for investors trading on margin. See, leverage magnifies the effect of even small price changes, so you could end up losing more than your original investment.
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