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Focus on the Futures
It certainly has been a wild few weeks on the markets, a sharp contrast from the upside we’ve seen for the past four years. I know our clients are at different levels of confidence and experience and that there are varying backgrounds with regard to trading vehicles. In these markets, a review of the basics of futures and futures trading will be relevant and useful for everyone. Futures are the most popular choice for Safety in the Market traders.
Futures – A Definition
Future contracts are an agreement to buy or sell a commodity or financial asset for future delivery or settlement. The price is agreed upon at the time the transaction occurs and the settlement period concludes with the expiry of the contract. The contracts are traded through a futures exchange, which ensures the fairness of the transactions and provides financial backing. The contracts are standardised in terms of quality and quantity. Standardising ensures that they are easily bought and sold. The only real variable is the price.
When I first heard of futures I thought that I had discovered the nirvana of markets – something purely set up for making profits. However futures contracts serve an extremely useful function in terms of risk management. Yes, risk management! All futures contracts have an underlying physical asset or instrument. This is most easily understood when you consider commodities like Wool, Wheat, Gold, Currencies, etc. Movement in the underlying price of these commodities is based on supply and demand. The futures prices move in parallel with the price of the physical commodities. Hedgers will use the futures market to protect against adverse price movements in the underlying asset.
A Quick Hedge Example
A farmer has wool to sell in a few months. To lock in the price he can sell his wool now on the futures market. The quantity for each contract is standard (2500kg in the case of wool futures), so the farmer needs to determine how many kilograms of wool his sheep will produce in order to sell the right number of futures contracts. If the price of wool has fallen by the time he harvests his wool the difference will be reflected in the price of the wool futures he sold. He can then buy out of his wool ‘hedge’ position for a profit. The amount of this profit will cover any downgrade in the money he received for selling his wool clip. He effectively went ‘short’ on the wool market.
Opening and Closing a Position – Trading in Futures
You can close out of your ‘position’ any time before expiry by simply taking an equal and opposing position. If you entered ‘short’ by selling two contracts you can exit that ‘position’ by buying two of the same contracts. You must use the same contract month to cancel out the position.
Leverage through Margins
When entering into a futures position you are not required to put up the full value of the contract you are trading. Just a margin is required, which is essentially a deposit. Margins are typically only around 2-5% of the value of the contract, which gives futures excellent leverage. The margin requirements are controlled by the futures exchange. The margins are like a ‘buffer’ for each open position in the market to cover risk.
A Leverage Example on the SPI200
Let’s take a look at an example for the SPI200 stock index contract. The underlying physical asset for the SPI200 is the ASX200. Fund managers would use the SPI200 futures as a hedging vehicle for adverse movements in their share portfolios. As traders we want to trade movements in the contract for profit. The SPI200 has a point value of $25. Therefore with the contract trading around 5800 points, the contract has a ‘nominal’ value of 5800 x $25 = $145,000. One SPI200 contract is effectively the same as trading a parcel of shares that reflects the ASX200 movements.
The margin required to open one position on the SPI200 (short or long) is currently $8000. That margin allows you buy or sell a contract trading at 5800 points, for instance, that would be worth $145,000! Let’s say that you bought one contract at 5800 and later that week sold it 5950. The contract has risen in value, 5,950 x $25 = $148,750. The profit of $3,750 ($148,750 - $145,000) plus your margin of $8,000 is returned to your account. This example doesn’t include brokerage; low effective brokerage is another key benefit of futures. The brokerage on this transaction is typically $50 total. Buying and selling $145,000 worth of shares for $50 is not a bad deal.
There is more to discuss on the intricacies of trading futures, but we will leave that for another time. If you are interested in learning about how to trade futures sooner rather than later, an Interactive Trading Workshop will get you up to speed quickly. Once you have become comfortable with futures markets you will find they provide a marvelous trading vehicle. They are simple to trade, allow easy use of stops and have tremendous leverage power. I’d suggest that you take the time to learn more about these highly profitable trading vehicles and discover how they can make a difference to the bottom line.
Until next time…
Noel Campbell
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