In finance, how do futures work?
Interested in the world of investment? Then read on to learn more about futures contracts. How do they work and what are they used for? We tell you all you need to know!
In the world of investment, a futures contract (or future) is a financial product enabling someone to commit to buying or selling an asset at a predetermined price and time.
Futures were originally used by commodities producers (e.g. farmers) wanting to protect themselves against fluctuating market prices. They entered into a futures contract with a client, agreeing on a price and a delivery date. If prices then fell, the farmer was therefore still able to sell his crop at the agreed price. Nowadays, futures are more commonly used as a speculation and/or risk management tool, but the principle remains the same.
How does a future work?
Futures are primarily used by arbitragers and asset management professionals. When in the form of standardised contracts, they are mainly traded on regulated markets. Without getting into too much detail here, there are also non-standardised futures which are not traded on a regulated market with a clearing house. Currency futures are one such example.
A future involves an issuer (the seller) and an investor (the buyer) entering into a contract to buy or sell an underlying asset (share, bond, stock market index, commodity, currency, etc.) at a predetermined price and on a specific date (the delivery date).
Unlike options, futures constitute a firm commitment. The two parties are legally obliged to honour this commitment to buy or sell on the delivery date.
How to trade in futures
Do you think that an underlying asset (the CAC 40 index, for example) is going to go up? If so, you can commit to buying a future on this index, under which you are legally required to buy it (or its cash equivalent) at a predetermined price and on a specific date. If, however, you think that this asset is going to go down, you have the option to sell futures contracts on this index.
To buy or sell a future, you need to pay a security deposit (…) aimed at hedging risks in the event of prices changing unfavourably.
The security deposit
In order to open your position (buy or sell a future), you need to pay a security deposit. This is payable to the clearing house (the financial body responsible for the settlement and delivery of transactions as well as for margin calls) if the contract is traded on a regulated market.
This security deposit is aimed at hedging risks in the event of prices changing unfavourably. It tends to be between 5% and 10% of the value of the contract and must be paid when the position is taken out.
Value of the contract
The value of a futures contract depends on the value of the underlying asset and the price of the product. As such, if one point on the CAC 40 is valued at €10 and the index stands at 2,500 points on the delivery date, the future will be worth €25,000 (2,500 x 10).
⇒ Remember, this amount (€25,000) is not the price you pay to take out your position on the future; it is the nominal value to which you are committed. To make your commitment, you must pay between 5% and 10% of this value (the security deposit).
How does a future actually function?
Delivery date
The delivery date (or maturity) is the date on which the future ceases to be valid. It is usually the third Friday of the delivery month and can be monthly, quarterly, half-yearly or annual.
By adding up all the margin calls (paid and received) throughout the term of the contract, we can see whether the investor has made a profit or a loss.
Margin calls
Throughout the term of the contract, the clearing house calculates gains and losses on a daily basis. These are known as margin calls, which are credited to or debited from the investor’s account on a daily basis and vary according to the settlement price, i.e. the latest prices of the underlying asset. If there is not enough money in the account, the security deposit can be used to pay the margin call.
In practice, if an investor closes their position (sells or buys the contract) before the delivery date, the margin call will correspond to the difference between the price on liquidation and the previous day’s settlement price.
If the investor chooses to hold their position until the next day (also called a rollover or overnight position), the margin call will then correspond to the difference between the settlement price on that day and the previous day’s settlement price.
Example: You think that the CAC 40, currently at 2,500 points, is going to go up. You decide to take out a future. At 3pm, the CAC 40 is trading at 2,560 points. You decide to sell your future. At market close, you have gained 60 points. At €10 for every point, you have therefore made a profit of €600 (60 x 10). This amount is credited to your account. However, if the CAC 40 is trading at just 2,460 and you sell, you will lose €400 (40 x 10).
By adding up all the margin calls (paid and received) throughout the term of the contract, we can see whether the investor has made a profit or a loss.
⇒ Please note that most of the time, there is no delivery of the underlying asset because the payment is made in cash. However, it is advisable to close your position before the delivery date to avoid physically ending up with the product on which you were speculating (in the case of a purchase) or having to supply it (in the case of a sale).
Example: Let’s say you have decided to speculate on wheat or gold. If you don’t close your position before the delivery date, you will actually physically end up with that gold or wheat rather than with the gains (or losses) associated with speculating on its value!
What can a future be used for?
As we have seen, a future enables you to anticipate fluctuating market prices. But it also has several other benefits:
- Leverage: futures can galvanise your portfolio’s performance by enabling you to speculate on changes in an underlying asset with considerable leverage. If you have called it right, you can multiply your gains while paying only the security deposit. In the example we used earlier, the investor paid a security deposit of €1,250 (5% of €25,000) and made a profit of €600 at market close. Their return was therefore 48% (600/1,250) compared with the market increase of 2.4% (60/2,500).
- Regulated trading and settlement: the majority of futures are traded on regulated markets, meaning that the specific features of each contract are determined in advance.
- No counterparty risk: since the clearing house takes care of the security deposits and margin calls, there is no counterparty risk (i.e. the risk of non-payment by one of the parties).
- Hedging in the event of falling prices: if you think prices are going to fall, you can take out a short future position on one of your portfolio assets. This means you will sell it at its current price. If you called it right and the price falls, your future will be sold at the predetermined price and the gains you make will partly offset the loss resulting from the falling prices in your portfolio.
While these benefits are appealing, you must remember that, like any other investment product, futures do entail some risks.
Leverage means of course that losses as well as gains can be multiplied. You must also keep an eye on the volatility of the underlying asset, because the more volatile it is, the greater the change in margin calls and therefore the higher the risk of losing capital. Lastly, futures offer no capital guarantee, which means that you may lose all of the money you invest, or maybe more.
So, now you know the basics of how a futures contract works. That being said, because of the risks associated with this type of investment, we recommend that you still consult a professional and establish your investor profile before taking the plunge. Good luck!
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