A futures contract is an agreement to buy or sell an asset at a future date at an agreed-upon market price. One party would agree to buy a given quantity of securities or commodity and take delivery on a certain date. This contract would be a standardised agreement, trading upon a regulated exchange.
Future contracts were initially devised as a hedge against potential volatility in the underlying asset it represented.
As an example, let’s imagine a corporate or a government entity making a delivery of a commodity, like oil. They could use the relevant futures contract to fix at a certain price, which would remove any risk at the time of the transaction.
But not every investor necessarily wants to exchange a product in the future. Many may wish to make a return on the buying or selling of the actual product itself. In doing so, these types of contracts have become widely accepted as a regulated instrument to speculate on the future price of the underlying asset they represent.
Futures contracts are also seen as a liquid way to invest, without having to take delivery of the underlying asset. This applies to commodities, bonds and equity indices.
When it comes to the best way to learn futures trading, it’s important to recognise that each contract will typically specify all the different contract parameters, which include:
- How will the trade be settled? The options being by physical delivery or a cash settlement
- The unit of measurement. This defines a trader’s exposure per contract
- The currency unit in which the contract is denominated and quoted. These could differ
- The grading of the underlying asset with certain commodities, for example
- The time to expiry of the contract, which will, in turn, influence the underlying value
It’s important to recognise that each futures contract will have a pre-determined end date. The most typical being on a quarterly basis — in the third or fourth week of the last month of the quarter itself. On or near this expiry, the time decay will be limited. This means that the futures contract will trade close to the underlying contract. Whereas early in the life of the contract, when there’s a significant time period, the futures contract will most likely trade at a premium to the underlying instrument. Of course, this depends on the market conditions at the time.
For more sophisticated investors, there are opportunities to arbitrage between futures contracts with different expiry dates. This would be described as ‘spread trading’.
Learning to trade oil and emini futures
When considering live contracts, it’s good practice for the trader to learn to trade oil futures and learn to trade emini futures.
For example, West Texas Intermediate (WTI) Crude Oil futures, on the Chicago Mercantile Exchange (CME), can be used to hedge against adverse oil price moves. They can also be used to speculate WTI oil prices, determining if they’ll rise or fall. There are monthly expiring contracts to trade out 10 years. In this example, each oil future represents 1,000 barrels of WTI oil.
The CME also offers emini S&P 500 and NASDAQ futures. This provides one of the most efficient, liquid and cost-effective ways to gain market exposure to the S&P 500 Index and NASDAQ, respectively, without physically owning the largest constituents.
Futures trading — risks and opportunities
By its very nature, futures trading is risky. It requires that traders and investors, in particular, aren’t simply familiar with all the risks, but also possess the skills and experience to manage them.
One of the main risks that comes with futures contracts is leverage. An exchange will set a margin requirement that’s deemed appropriate for managing risks at a clearing house level. This will be calculated on a daily basis. For example, the minimum level of margin required for most gold futures contracts is 2.5%, which implies a leverage of 40 times.
It’s important that investors are fully aware of the leverage as it relates to the underlying contract and taking large exposures with a small upfront cost. So, the greater the leverage, the greater the gains. But the greater the potential loss could be as well. As an investor, it’s important to be particularly disciplined in futures contracts. This is in order to avoid overexposure to one asset within a portfolio, and, in turn, to undue risk.
Settlement and delivery
This flows neatly into settlement and delivery risk. Executed trades will have to be closed and settled. Daily settlement takes the form of automated (in most cases) debits and credits. Any shortfalls would be recovered via margin calls. In this case, traders are required to satisfy all margin calls. Any non-payment of a margin call could pose a serious risk and can lead to a forced closing of the position.
Similarly, with delivery risk, it’s very important that the trader is aware of their potential commitment to physical delivery — should the investor hold the position to maturity of the contract. This is very relevant to commodity futures, although some have a cash settlement process at expiry.
Liquidity and operational risk are also important to highlight. As with all assets, the level of liquidity should be an important consideration when making a decision to trade or not. When arriving at a strong trading view, the investor may find that there’s not enough liquidity to execute the trade.
Importantly, when the trade is executed, there may be a risk that it could become costly to exit from positions in an illiquid contract. So, it could be important to check with the broker on the liquidity status before embarking on a trade.
However, futures do tend to be highly liquid. For example, the US Treasury Bond futures contract is one of the most heavily traded investment assets in the world. Operational risk is more relevant with futures contracts, even when dealing with strongly regulated brokers. There will be a daily margin call to calculate, which may bring into play the risk of manual or internal control errors.
This practise also attracts machine learning futures trading techniques, which brings into play algorithms within a quantitative model. When considering trading futures, it’s recommended that traders familiarise themselves with this method of trading. It’ll, in part, involve chart technicals and the analysis of historical market behaviour using large data sets.
Futures can be considered appealing because of the leverage they provide. Strong returns can also be secured on a small amount of invested capital. But risk management is a particularly important consideration. Caution is advised as the cost of leverage, and its daily margin call, can lead the trader to lose more than the balance of their account.
However, trading futures on a regulated exchange, like the CME, can be very fruitful for all types of investors. The opportunity to trade an underlying commodity or equity index with considered leverage is matched, in the main, by a liquid market. The instrument in question can be used as a hedge for a diverse portfolio or an outright long or short position
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