Common Questions About Futures Trading

The futures market can be an intriguing and slightly puzzling concept for investors unfamiliar with futures trading. Here are some answers to common questions many people have when beginning to investigate futures for the first time. This list is by no means comprehensive, but it should give you a basic understanding about futures.

What is a Futures Market?

A futures market is where people trade futures contracts. This is called futures trading.

What Are Futures Contracts?

Futures contracts are legally binding contracts to buy or sell a particular product or commodity on a set date at a price agreed today. It allows companies to set a definite value for trade and protect against potentially fluctuating market conditions (also known as hedging).

What Type Of Products Are Sold Under Futures Contracts?

You may find the range of products sold under futures contracts surprising. The stock exchange regulates many types of futures contracts, and popular underlying assets for futures investors include commodities such as gold, oil or agricultural products, share futures or futures contracts tracking stock market indices (such as the ASX futures), interest rates such as bonds or even energy (for example, electricity).

How Do Investors Make Money On Futures?

Individual investors make money by predicting the market fluctuations. Futures give investors the unique ability to speculate on any market direction, which means you can make money whether the underlying asset prices rise or fall as long as you predict the market movement correctly.

I Think Market Prices Will Rise. How Do I Profit From This?

If you believe market prices on a certain asset will go up, you need to buy low and sell high. This is called 'going long'. Let's say you buy a futures contract for oil trading at $40 per barrel believing prices will rise.

Scenario 1 - At the end of the week, prices go up to $43 per barrel. You decide to sell the contract to make a profit (how much depends on your exposure to the market).

Scenario 2 - After several weeks, the price is down to $37 per barrel. You want to sell the contract before it matures so you take on a loss (again, the amount depends on exposure).

I Think Market Prices Will Fall. How Do I Profit From This?

If you believe market prices will go down, you need to sell high and then cover low. Futures give you the unique ability to sell a contract without owning it with the promise to buy it back later. To profit, you need to sell a contract while prices are high and buy it back lower (the difference is your profit).

Of course, if prices rise, you must buy back the contract at a loss, so it's important to base any market predictions on thorough research.

How do I Make Worthwhile Profits from Such Potentially Small Price Fluctuations?

Perhaps the most attractive thing about futures contracts for individual investors is the ability to gain leverage. Futures contracts are standardised contracts regulated by your stock exchange, and to purchase a contract only costs you an initial margin.

To illustrate this concept, imagine you want to expose $5000 of your capital to an investment. If you were to buy shares, you could only purchase $5000 worth of shares, and your profits would be limited to this. However, with a futures contract your $5000 paid as an initial margin will expose you to a much higher amount, let's say $100,000 for the sake of clarity.

With this much leverage, even small price fluctuations can mean profits stretching into the thousands. Conversely, you are also exposed to high risk if the market moves against you. Your potential for loss is almost without limit in the worst-case scenario. For this reason, many people utilise options contracts in place of futures contracts.

Who Works Out The Margins?

The initial margin is usually calculated on a historical price basis, and as mentioned, all contracts are standardised to ensure fair trade. However, it is also important to note that you may also have to pay variation margins depending on how your contract travels as market prices shift.

If the market moves against you, your account may be debited to cover any variation, and likewise you should receive credits for any positive movements. For example, let's say a price swing causes your contract to attract an unrealised loss of $1000 - that amount would be taken from your account and so on until the contract is settled or closed out.

Your broker may use other assets to cover variation margins, and these are typically settled at the end of each day. You also receive your initial margin back on settlement and you may have to pay broker fees or other associated costs.

What Do Market Participants Gain From Futures Markets?

Futures contracts allow financial risk to be spread among market participants (both individual investors and companies), and they also provide transparency on prices. We've shown how individual speculators can profit from fluctuating market prices, and as mentioned, companies can hedge or protect against risk by utilising futures contracts.

Regardless of whether the prices move higher or lower on the market, any profit or loss can be offset with a futures contract. For example, let's say a electronic components company takes out a futures contract to purchase gold for $900 an ounce in six months. Any gold price rises become irrelevant because the contract locks in the purchase of gold for that amount, and losses made on the futures contract are offset from being able to purchase gold at a cheaper price.

How Are Futures Contracts Settled?

Futures contracts can be settled a number of ways. Firstly, it is common for futures contracts to be 'closed out' before the contract comes to maturity, and you close out your position by performing an equal but opposite transaction with another party. For example, if you bought a futures contract, you would have to sell one of the same type and maturity, and vice versa.

This is often called offsetting or liquidating the position, and once you close your position, it effectively cancels your obligation to the contract. The difference between the contract price and the market price determines your profit or loss on the trade.

If you hold on to the contract until maturity, it can either be cash settled or in some cases you may have to organise physical delivery of the goods in question. Cash settlement is more common, and basically you settle any differences in between contract prices and market prices with cash. If market prices have fallen against the contract, the buyer will owe the seller money and vice versa.

For contracts that result in physical delivery upon maturity, you will have to check details with your stock exchange about the process that occurs. In some cases, the exchange will help facilitate the delivery, which often transpires at an appropriate location near the exchange itself. Sometimes, other terms or delivery details are negotiated as part of the contract settlement.

It's important to understand the type of futures contracts you are trading and the relevant maturity dates to avoid any trouble or confusion.

Can I Purchase Futures Contracts From A Regular Broker?

Just like when you buy shares, you need to use a broker to purchase futures. A stock broker needs to have a special license and technology to trade in futures, and many stock brokers will also trade in futures. In addition, you can utilise non-advisory brokers and full service brokers depending on the level of advice and expertise you require.

What Is The Difference Between Futures and Options Contracts?

Although you often hear the terms used together, options contracts and futures contracts are two different things. The main difference between the two is that an options contract gives you the right but not the obligation to buy or sell an asset, whereas a futures contract is a legally binding contract ensuring a sale.

The advantages and disadvantages of options are unique, but basically, an option is an alternative to those who want to reduce the risk normally associated with the futures market. With an option, the most you can lose is the premium you pay for the options contract itself, but with futures contracts, your losses are almost unlimited if things go wrong.

What Are ASX Futures?

The ASX offers futures and options contracts on the Australian stock exchange, and this includes the ASX SPI 200 Index Futures and ASX SPI 200 Index Options, which both track the Standard and Poor's market indices. You can also find online trading simulators and other information from the ASX website.