Jordan Craw

 

Following on from the previous E-Ticker article, Stock Weightings on the SPI 200, this article aims to give new traders a stronger understanding of Futures Contracts and their purpose within the financial markets.

A Futures Contract is a standardised forward contract or agreement between two parties conducted via a Futures Exchange. Futures contracts are either deliverable or cash settled on expiry. As a general rule, Stock Index, Currency and Financial Futures contracts (Bonds, Bills) are cash settled, and Commodity based contracts are deliverable. It is interesting to note that only approximately 2% of these contracts are actually delivered!

To break a Futures contract is simply a matter of taking an equal and opposite position. This is important to note when understanding the concept of short selling. Making it possible to sell to open a position and buy to close, taking the difference between these two points as profit (or loss). This is opposed to the reverse sequence the average investor applies to buying and selling stocks. Rest assured the fundamental concept of “Buy low, sell high” does not change, just the order! As shown in the examples below.


Figure 1. “Long” Trade


Figure 2. “Short” Trade

The earliest recorded use of an organised Futures contract dates back to 17th Century Japan. These contracts were based on rice. Over time "Rice Tickets" became an accepted currency and once again we can see parallels to modern financial instruments - in this case currencies. These days Futures can be broken up into six major categories.

  • Stock Index Contracts
  • Currencies
  • Financials
  • Soft Commodities
  • Metals
  • Share Futures

 

The main participants in the Futures Market today are Commodity producers and merchants, Banks and large Financial Institutions, Local Traders, Market Traders, and Corporations.

The main reason many Futures markets continue to exist is for hedging purposes. For example, a Fund Manager may construct their portfolio to mirror the S&P ASX 200 Index, based on the weightings outlined in my previous article. They may then use the SPI 200 Futures as an “Insurance Policy” if they were given a signal that the market was due to decline. Because of the leverage available on futures, it would cost roughly 2-3% of the total portfolio to take this position to 100% protection. A fairly small insurance premium I think you’d agree.

To give you an idea of the amount of money that is traded in these markets, the CME (Chicago Mercantile Exchange) ran an ad in the August- September 2001 edition of Your Trading Edge stating that in the first quarter of 2001 alone, over 120 Trillion Dollars worth of contracts were traded through the Exchange. I don’t know about you, but I’m sure many of us would be happy with 0.0000005 % of that!

Until next time happy trading.