Futures 101, with CME Group

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This piece is the first of three articles designed to introduce futures and the role they play in a portfolio. Futures are more commonly used by institutional investors, so this series aims to demystify them for retail investors by explaining what they are, their benefits, common terms, and risks. In addition, a worked example demonstrates how investing in futures works. The following articles dive deeper into different types of futures: micro futures with a focus on equity index and crypto.

1. What are futures?

1:03 min read

Futures might sound complicated, but if you strip out the jargon, they’re simply contracts that let you buy and sell an asset for a set price at a later date. When it’s time to settle, you’re obliged to buy or sell the underlying asset at the agreed price regardless of its current price. That’s different from options, which let you buy and sell the underlying asset without the obligation.

You can trade futures on a range of assets including commodities, stock indexes, currencies, precious metals, interest rates, and even cryptocurrencies. The contracts are all standardized and trade on a futures exchange, so you can transfer or trade a futures contract as you would a stock, without fear of the other party defaulting.

Futures also make it easier for you to short assets – that is, to sell the underlying asset without owning it. There are fewer limitations associated with shorting assets using futures compared to a normal brokerage account. If you want to short sell an asset, you can “sell” a futures contract and profit if the price lowers in the future. And because futures are traded on an exchange with good liquidity, getting in and out of trades without a large transaction cost is a lot easier.

2. Why trade futures?

1:47 min read

Investors who trade in the futures market usually have one of two aims: to hedge the price of an asset by locking in a future price or to speculate on the price direction of an asset. The latter group – also known as “speculators” – seek to profit from the ups and downs of futures prices.

Here’s an example: traders who expect oil prices to be substantially lower in a year could sell a futures contract that obligates them to sell oil at today’s price one year from now. If their predictions are right, they would profit from the price difference between the contract’s price and the price of oil when the contract expires. But if they’re wrong, they’ll make a loss. Now, a refiner could take the opposite end of that traders’ contract: they’d choose to buy oil at a fixed price a year from now because they want to hedge their input cost, by lowering the risk that they’d later have to buy oil to refine at a higher price than today’s.

There are a few reasons to trade futures. For one, they can help diversify your portfolio. For another, they could potentially allow you to profit from your outlook on asset prices while providing a hedging benefit if you’re looking for price stability. Bear in mind, though, that hedging works both ways, so locking in the price now could also mean you lose out on favorable price movements. Plus in other jurisdictions like the US, you could benefit from tax advantages depending on the long and short-term capital gains tax rates.

And then there’s leverage: see, the upfront capital required for futures is often substantially lower than the contracted value – although your gain or loss is still calculated as if you’d deposited 100% of the contract. With leverage, it is possible to lose more than the amount you deposited. Therefore, you should only use funds you can afford to lose without affecting your lifestyle and only a portion of those funds should be devoted to any one trade because not every trade is likely to be profitable.

3. What’s the key terminology?

1:30 min read

Before you start trading futures, you should be familiar with a few key terms:

Expiration: While stocks can be held in perpetuity, futures contracts have an expiry date. Any position you hold is automatically closed once the contract expires.

Settlement: This is the method by which specific contracts are “settled”. Usually, that’ll be with cash or by physical delivery of the asset, but your form of settlement will depend on the underlying asset. For example, unless you have a business that requires underlying assets like certain energy, metals, and agricultural products, you’ll most likely never take the physical delivery of a commodity. In fact, most futures contracts are offset – that is to take the opposite side of the transaction to eliminate any delivery obligation – before expiration, and very few actually go to physical delivery. You can check with your broker about futures’ delivery processes.

Mark-to-market: This is the process of calculating the current market value of your futures contract daily, rather than letting your profit or losses accumulate before settling when the contract expires. This way, all accounts between the involved parties are settled twice daily, and losses can’t snowball.

Margin: When you trade futures, you only need to put down a small amount of money as collateral – your “initial margin”. That’s usually a percentage of the value of the futures contract, meaning your margin is only a small portion of the notional value of the contract. But to keep holding your position, you need to make sure you have enough surplus funds, known as your “maintenance margin”. See, because the value of the future is adjusted daily, your deposit as a proportion of the overall value could drop below the required amount. If that happens, you might face a “margin call” that requires you to top up funds.

4. Worked example: hedging your portfolio with futures

1:01 min read

Let’s see how you might use futures to hedge portions of your investment portfolio.

You currently own 1,000 shares of McDoodle stock which have appreciated in value. Ideally, you’d like to sell them at their current price of $100 a share, but for tax reasons, you’ll need to hold them till the end of April.

At its current price, you expect to receive $100,000:

1,000 shares x $100 per share = $100,000.

To lock in this current price, you could sell ten “100-share” McDoodle futures contracts priced at $100, expiring at the end of April. This means you’re obligated to sell 1,000 shares of McDoodle at $100 per share when the contract expires.

By the end of April, you’ll have made $100,000 – no matter whether McDoodle prices are at $80 or $120.

$80 per share:

$80 x 1,000 = $80,000 (open market share sale)
($100 – $80 = $20) x 1,000 shares = $20,000 (futures contract gain)
Total gain: $80,000 + $20,000 = $100,000

$120 per share:

$120 x 1000 = $120,000 (open market share sale)
($120 – $100 = $20) x 1,000 shares = –$20,000 (futures contract loss)
Total gain: $120,000 – $20,000 = $100,000

The futures market was originally created to help market participants hedge risk, but it’s speculators who help provide liquidity and risk transfer to the marketplace. As you can see, futures can help with price hedging, and you can vary the amount or type of product hedged depending on your market view and preference.

5. What are the risks?

Less than 1 min read

The price of a futures contract depends on factors like interest rates, time until expiration, storage costs, and the price and volatility of the underlying asset. And as always, the type of investor you are dictates the risks you take on.

If you’re purely speculating about the price of an asset, you risk taking a loss if prices move against your expectations. But if you’re using futures to hedge, your loss is limited to missing out on potential gains.

The more leverage used, the higher the risks for investors trading on margin. See, leverage magnifies the effect of even small price changes, so you could end up losing more than your original investment.

Trading involves risk, it is always good to have a trading plan and a risk management strategy when beginning your trading journey.

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