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Futures contracts

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A futures contract is a legally binding contract to buy or sell something at an agreed price on a future date. Futures can be linked to assets such as commodities, currencies, interest rates or a share market index.

How futures work

When you enter a futures contract, you agree to buy or sell an asset at a set price on a set future date. You usually pay an upfront deposit (or margin) towards the final full value.  

The value of the contract rises and falls as the market price of the underlying asset changes.  

For example, a futures contract might be based on: 

Futures are different from buying shares directly. You usually don’t own the underlying asset. Instead, you are entering a contract whose value depends on the price movement of that asset. 

A futures contract has an expiry date. At the end of the contract, it may be settled in one of two ways. 

Cash settlement means you receive or pay the difference between the contract price and the final settlement price. 

Physical delivery means you may have to take or make delivery of the underlying asset.  

If you’re trading futures, make sure you understand how the contract will be settled before you enter into it. 

Leverage increases your risk

Because futures use leverage, you only pay a small percentage of the contract value upfront, known as a margin. This gives you exposure to a much larger investment than the amount you initially invest. 

Leverage can increase gains if the market moves in your favour, but it can also magnify losses. In some cases, you can lose more than your initial investment. 

If the market moves against you and your losses become too large, your broker may require you to add more money to your account to keep the position open. This is known as a margin call. If you cannot meet a margin call, your broker may close your position and realise the loss. 

Who uses futures contracts

bean prices rise before it needs to buy stock. A company that imports products from overseas may use currency futures to help manage the risk that exchange rates move against it. 

Traders might use futures to try and predict which way a price is going to move and profit from the change. For example, they may use futures to bet on the overall directional movement of a market, by buying or selling index futures. This is called speculation. 

Buying a futures contract

Buying a futures contract is called “going long”. When you buy a futures contract, you’re entering into a legally binding agreement to buy an asset, or settle the contract, at a future date for a price that you’re agreeing today.

Going long = agree to buy, hoping the price rises.

You’re making a prediction that the value of the asset you’re agreeing to buy is going to increase in price between now and then. If it does, the value of your futures contract will increase.

Example: Going long

Ben believes the Nasdaq is going to increase sharply over the next few months. 

Instead of buying shares across the market directly, he buys one Nasdaq-100 Index futures contract, which gives him exposure to movements in the Nasdaq index. 

Ben pays a 6% deposit of $12,000 for exposure to $200,000 worth of the index. 

Ending 1: The index falls – Ben loses all of his initial margin 

Three months later, the Nasdaq-100 Index has fallen by 10%.  

As a result, the value of the futures contract falls from $200,000 to $180,000. 

This means Ben loses $20,000, which is more than his $12,000 initial margin. He loses all of his initial margin and needs to pay an additional $8,000 before fees, interest or any further margin call obligations. 

Although the index fell by only 10%, Ben loses more than the $12,000 he initially paid because the futures contract gave him exposure to a much larger position. 

Ending 2: The index rises – Ben makes a large return on his margin 

Three months later, the Nasdaq-100 Index has increased by 10%. 

As a result, the value of the futures contract rises from $200,000 to $220,000. 

The $20,000 gain is credited to Ben's position. When he closes the contract, he receives He closes out the contract, receives his original $12,000 margin back plus the $20,000 gain, giving him a profit of $20,000 before fees and other costs. 

Although the index increased by only 10%, Ben makes a 167% return on his initial margin because the futures contract gave him exposure to $200,000 worth of the index while only requiring a $12,000 upfront margin payment. 

Note, this example is simplified and excludes fees, interest and margin calls. 

Want to see the workings?

  • Value of futures contract: $200,000
  • Initial margin paid: $12,000
  • If the index rises 10%
  • New contract value: $220,000 = profit: $20,000
  • If the index falls 10%
  • New contract value: $180,000 = loss: $20,000

 

Selling a futures contract

Selling a futures contract is called “going short”. When you sell a futures contract, you’re entering into a legally binding agreement to sell an asset, or settle the contract, at a future date for a price that you’re agreeing today. 

Going short = agree to sell, hoping the price falls. 

You’re making a prediction that the value of the asset you’re agreeing to sell is going to decrease in price between now and then. If it does, the value of your futures contract will increase. If the price rises instead, the value of your futures contract will fall and you may make a loss.

Example: Going short

Emma believes the Nasdaq is going to fall sharply over the next few months. 

She sells a Nasdaq-100 Index futures contract which which gives her exposure to movements in the Nasdaq Index.  

Emma pays a 6% deposit of $12,000 for exposure to $200,000 worth of the index. 

Ending 1: The index falls – Emma makes a profit 

 Three months later, the Nasdaq-100 Index has fallen by 10%.  

As a result, the value of the futures contract falls from $200,000 to $180,000. 

Because Emma sold the futures contract when it was worth $200,000 she can close out the contract and make a $20,000 profit. 

When she closes the contract, she receives her original $12,000 margin back plus the $20,000 gain, giving her a profit of $20,000 before fees and other costs. 

 Although the index fell by only 10%, Emma makes a 167% return on her initial margin because the futures contract gave her exposure to $200,000 worth of the index while only requiring a $12,000 upfront margin payment. 

Ending 2: The share price rises – Emma loses more than she invested 

Three months later,the Nasdaq-100 has increased by 10%. 

As a result, the value of the futures contract rises from $200,000 to $220,000. 

Because Emma sold the futures contract when it was worth $200,000, the $20,000 increase works against her. 

This means Emma's entire $12,000 investment is wiped out and she must pay an additional $8,000 to cover the remaining loss. 

Emma loses $20,000, even though she initially invested only $12,000. 

Note, this example is simplified and excludes fees, interest and margin calls. 

Want to see the workings?

  • Value of futures contract: $200,000
  • Initial margin paid: $12,000
  • If the index falls 10%
  • New contract value: $180,000 = profit: $20,000
  • If the index rises 10%
  • New contract value: $220,000 = loss: $20,000

 

Benefits and risks of trading futures

Possible benefits

Risks

Questions to ask before trading futures

Futures are not the same as buying shares or investing in a managed fund. They are complex, high-risk products that can expose you to large and rapid losses.

Before trading futures, ask yourself these questions.

Do I understand how the futures contract works?

Do I understand the risks?

Do I understand margin and leverage?

Is this product right for me?

Have I done my research?

Stop, consider the risks, and seek advice

This page covers the basics of futures contracts. But they are complex financial products.

Consider seeking independent financial advice before you invest and learn more about how to invest.  

 

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