Chapter 1 - The Essentials - MF Global Futures broker, Futures trading, CFD trading, online Futures trading

Chapter 1 - The Essentials

"A futures contract is a legally binding agreement made between two parties to buy or sell a commodity or financial instrument at an agreed price, on a specified date in the future. With futures contracts, the quantity and quality of the underlying commodity are specified and the future delivery date is fixed. The price is the only variable and is determined through the interaction of buyers and sellers at the time when the contract is first opened."

Futures Fundamentals

All futures contracts regardless of their type or size have a set of standardised features or specifications. The main features of a futures contract are:

Contract Unit

This refers to the quantity of the underlying instrument/commodity that the futures or options contract is based upon. For example, SFE's 10 and 3-Year Bond futures contracts are based on Australian Commonwealth Treasury bonds with a face value of A$100,000. The 90-Day Bank Bill Futures are based on bank bills with A$1,000,000 face value. In the case of Share Price Index (SPI(R)*) futures, the contract value is fixed at $A25 x All Ordinaries Index.

Tick Value

The minimum allowable price move in a futures contract is called a 'tick'. For example, the minimum 'tick' move in the SPI contract is 1 index point, which has a value of A$25.

Spot and Forward Months

As futures contracts essentially represent agreements to buy or sell in the future, investors are able to trade in many different delivery months, e.g. in April you could trade SPI contracts for June, September, December, and in March the following year, and so on. The contract that is closest to maturity (in this example the June contract) is known as the spot month. The other months listed are called forward months.

Termination of Trading/Expiry

The date and time at which a futures contract expires or matures.

Settlement

Futures contracts can be settled either by the exchange or delivery of the underlying commodity or else in cash. In a cash settled contract, the holder of the futures contact either receives or pays the difference in cash value between the traded price and the closing futures price. In a deliverable contract however, the actual transfer of the underlying commodity takes place between the buyer and seller.

*SPI is a registered trademark of the Sydney Futures Exchange Limited

Who participates in the futures market?

Trading with Futures

One of the major benefits of futures is that they can be used by investors to gain leveraged exposure to financial or commodity markets. The following example illustrates a typical futures trade.

Scenario

It is now early June and a private trader is of the view that the All Ordinaries Index will experience a short term rise. The trader wishes to take a trading position based on this view and so decides to BUY 5 All Ordinaries Share Price Index (SPI) futures contracts at the current market price of 3050. The trader's position now appears as follows:

2 June	Australian Sharemarket	Sydney Futures Exchange
	No trade - All Ordinaries Index stands at 3045	Buys 5 June SPI Futures at a price of 3050. Pays initial margins of approximately $3,000 per contract plus brokerage and exchange fees.

Over the next few days, the All Ordinaries Index strengthens as the trader predicted and the price of the June SPI contract rises 30 points to 3080. After reviewing the trading indicators, the trader decides to exit the market to realise the profit made. Accordingly, the trader instructs the broker to SELL 5 June SPI contracts to liquidate or 'close out' the original 5 contracts bought. The trader's position now appears as follows:

6 June	Australian Sharemarket	Sydney Futures Exchange
	No trade - All Ordinaries Index stands at 3075.	Sells 5 June SPI Futures at a price of 3080. Profit: 30 points x $25 per point x 5 contracts = $3,750 less brokerage and exchange fees Initial margins are returned.

Synopsis:
The trader was able to make a futures profit of $3,750 (before brokerage and exchange fees) by correctly predicting the future direction of the market. In making this trading profit, the following points should be noted:

Had the market not risen but instead fallen by 30 points, the trader would have shown a loss of $3,750. Had the market fallen further than this, the trader's loss would have been even more substantial. When trading futures it is entirely possible for traders to make losses that exceed the value of their initial investment.
Although the futures contracts purchased were due to expire at the end of June there was no requirement for the trader to hold the contracts until this time. Once opened, a futures contract can be liquidated by the trader at any time (ie. weeks, days or even minutes after it is first opened). To do this, the trader would simply sell June SPI futures back into the market to offset those originally purchased.
The example assumed that the Share Price Index (SPI) contract moved in tandem with the All Ordinaries Index (A0I). Although the SPI will generally move in the same direction as the A0I, there is no guarantee the two will move in tandem.

In this example, the trader decided to take a market view using five contracts. There is no requirement for traders to deal in this amount, the minimum transaction size is one futures contract.
The example showed the trader paying initial margins to support the position. In addition to this margin a daily settlement or variation margin would be payable to cover any adverse market movements that occurred after the position was first opened. Further details on the rationale and use of margins is covered later in this Handbook.
Had the trader been of the view that the market was going to fall rather than rise, the trader could have SOLD rather than bought SPI futures. In this instance, the trader would realise a profit if they were able to repurchase the contracts at a lower price than they originally sold them for. When selling futures there is no requirement for a trader to have purchased anything first. Unlike other types of investment markets where short selling is prohibited or restricted, it is just as easy to sell in the futures market as it is to buy. Traders therefore have the opportunity to make profits in a falling market as well as in a rising market.

Scenario

It is now July and a trader believes the short-term outlook for the Australian sharemarket is negative. The trader wishes to take a trading position based on this view and so decides to sell September Share Price Index futures at the market price of 3075. This trade will generate profits for the trader should the market decline as expected. The trader's position therefore appears as follows:

4 July	Australian Sharemarket	Sydney Futures Exchange
	No trade - All Ordinaries Index stands at 3040	Sells 2 September SPI Futures at a price of 3075. Pays initial margins of approximately $3,000 per contract plus brokerage and exchange fees.

Over the next few days, the Australian sharemarket declines as expected. In response, the price of September SPI futures fall 25 points to 3050. The trader decides to take profits at this level and so closes the position by buying back the two September SPI contracts originally sold. The trader's position now appears as follows:

7 July	Australian Sharemarket	Sydney Futures Exchange
	No trade - All Ordinaries Index stands at 3025	Buys 2 September SPI Futures at a price of 3050. Profit: 25 points x $25 per point x 2 contracts = $1,250 less brokerage and exchange fees. Initial margins are returned.

In this example, the trader profited from correctly predicting the fall in price of the SPI contract. As per the previous example, had the traders expectations been incorrect and the market in fact rose, the trader would have made a loss.

Hedging

In addition to using futures for trading, individual investors can also use the market to manage the risk on a portfolio of commodities, financial securities or equities already held. Such a strategy is known as hedging and is the core reason for the existence of futures markets. Below is an example of how a trader can use the SPI contract for hedging purposes.

Scenario

An investor has a share portfolio that is currently valued at A$225,000. The investor is nervous about the short-term outlook for the Sharemarket but does not want to sell the portfolio because of capital gains taxation considerations, loss of dividend income, stamp duty charges and brokerage costs.

To protect the portfolio from the anticipated market decline, the investor SELLS 3 SPI futures contracts at the current market price of 3000. By doing this, the investor is hoping to make profits on their futures hedge to offset any loss that may be incurred on their share portfolio in the event of a market decline. The investor's position therefore appears as follows:

5 March	Australian Sharemarket	Sydney Futures Exchange
	Holds a diversified equities portfolio valued at A$225,000 All Ordinaries Index at 2990	Investor sells 3 March SPI Futures at a price of 3000. Pays initial margins of approximately $3000 per contract plus brokerage and exchange fees.

Over the next few weeks, the Sharemarket declines as the investor predicted. By late March, the All Ordinaries Index has fallen approximately 2.5% or 75 points. This has reduced the value of the investor's portfolio by A$5,625 so that its current market value now stands at A$219,375. At the same time, the price of March SPI futures has fallen by 2.1% or 65 index points. This generates a hedge profit for the investor of A$4,875. The net result is that the value of the portfolio has effectively fallen by only A$750 (i.e.$5625 - $4875). Believing that the market decline is now over, the investor decides to liquidate their futures hedge. The investor's position now appears as follows:

28 March	Australian Sharemarket	Sydney Futures Exchange
	Diversified equities portfolio has fallen in value by 2.5% Now valued at A$219,375 Loss on portfolio A$5,625 Net loss: $5,625 - $4,875 = $750	Investor buys 3 March SIP] futures at 2935. Profit: 65 points x $25 x 3 = $4,875 less brokerage and exchange fees Initial margins are returned.

In this example the investor was able to use the futures market to ride out the market decline and was not forced into liquidating their share portfolio. This not only gave the investor peace of mind but it also meant that they did not have to incur the brokerage, stamp duty and taxation implications that would have arisen had the share portfolio been liquidated.

In reviewing this example, it is important that the following be noted:

The example assumed that the investor's portfolio was highly correlated with the All Ordinaries Index. This may not always be the case. Depending upon the extent of the correlation it may be necessary to adjust the number of futures contracts used in the futures hedge. In addition, if the portfolio exhibited a poor correlation with the index the SPI may not be the optimum product to use for the futures hedge. The investor may instead give consideration to using Dow Jones AP/ELS Australian Index futures or Individual Share Futures.
As in the previous example, allowances need to be made for the possible payment of variation margins. These have to be paid daily to cover adverse price movements on the futures contracts held. Possible cash flow implications may arise due to the need to pay these margins on a daily basis while the gains made on the physical portfolio are unrealised (ie. they will only be realised once the shares are sold).

Futures versus other derivatives

In recent years, private traders have been able to access a diverse range of derivative products. Some of the major products available include:

Equity and Currency Options

These are leveraged instruments that allow traders to obtain the right but not the obligation to buy or sell equities, equity indexes or currencies at predetermined prices. In exchange for having this right, the investor pays a sum of money called a premium. Options can be a very useful tool to exploit expected price changes in the market and have the added advantage that the buyer of an option can only ever lose the premium paid. Options however can be complex in terms of their price behaviour and are typically less actively traded (i.e. less liquid) than the major futures contracts traded on SFE.

Exchange Traded Warrants

These are essentially options that are issued and secured by a third party such as an investment bank. They have many of the same benefits as options and have an added advantage in that many warrants can be purchased with long maturities, this is suitable for traders who have a long term market view. Like options however, the pricing of warrants can be complex and some classes of warrants can be relatively illiquid. In addition, the fact that warrants cannot be short sold means that investors may find it difficult to capitalise on market opportunities such as an expected decline in volatility levels.

Terms

Like any industry, the futures market has it's own language. Below are examples of common terms that are used.

To be long futures

To be long, a futures contract or to go long futures means to buy a futures contract. The purchase of a futures contract locks the buyer into an agreement to purchase a commodity or security on a specified date in the future. at a price agreed upon today. For example, the purchase of a wool futures contract locks the buyer into a price to purchase the wool at a specified date in the future.

To be short futures

To be short, a futures contract or to go short futures means to sell a futures contract. The sale of a futures contract locks the seller into an agreement to sell a commodity or security at a specified date in the future, at a price agreed upon today. For example, the sale of a wool futures contract locks the seller into a firm price for the sale of wool.

Volume & Open Interest

Trading volume is the number of futures transactions that took place during a trading period. ie. how many contracts (lots) were traded. Open interest is the number of outstanding futures contracts, or the total of short and long positions that have not yet been closed out by delivery or by reversing a position. Open interest is commonly used by traders to gauge the size or extent of participation in a particular market.

Bid

The price at which buyers are currently prepared to pay.

Offer

The price at which sellers are currently prepared to sell.

Disclaimer: This website contains general information only and does not constitute financial product advice. Derivative products can be risky and are not suitable for all investors. MF Global Australia recommends customers seek independent advice. A MF Global Australia Product Disclosure Statement (PDS) is available through the website www.mfglobal.com.au and should be considered prior to trading MF Global's derivative products. Investing in derivatives carries a high level of risk to capital, and due to the potential volatility and fluctuations in value, investors may not get back the amount of their original investment. In certain circumstances an investor may be liable to pay a far greater sum, with losses being higher than an initial deposit.