What is Futures? How to and Should I Trade it?
Many investors may hear the word "futures" on the buzzy market from time to time, but few of them truly know what futures are and how futures can help them ride out the market fluctuations. In particular, the capital market witnessed a dramatic bearish trend this year, wiping out numerous returns. Fortunately, the use of futures can give investors more leeway to earn profits even amid frequent ups and downs. Next, we will walk you through every fundamental aspect of futures, to guide you on how you should take advantage of futures to protect your asset values.
What are Futures?
Futures are derivative contracts binding both parties to buy or sell an asset at an agreed future date and price. In other words, the buyer is obliged to buy while the seller must sell a certain amount of the underlying asset at a given date and price, no matter what the market price is.
The futures contracts are often traded in an exchange covering a variety of commodities and securities. On the futures market, many financial players, including consumers, institutional producers, investors, and speculators, resort to futures to earn profits or reduce their risk exposure.
To trade futures, investors also need to put in a margin, serving as both the collateral kept by a broker or exchange, or the leverage eliminating the need to deposit 100% of the contract's value. The margin will be taken by the broker or exchange if the price of the underlying asset moves opposite to the investors' expectations.
If the leverage ratio of the futures is set to 1:10, a 5% change in the price of the underlying asset will result in a 50% gain or loss. This means trading futures is an advanced technique that requires certain knowledge and experience.
Example of futures
The assets covered in the futures can include a wide range of commodities and financial instruments, such as soybeans, crude oil, natural gas, securities, and even cryptocurrencies.
Let's say you want to earn profits on the share price of a listed company by entering into a futures contract effective from July to December. The stocks of this listed company are traded at 50 HKD per share in July, with one lot consisting of 1,000 shares. Of course, you don't need to pay 50,000 HKD to purchase one lot of shares because you only need to deposit a fraction of the money into your margin account.
Later in December, the share price ultimately rises to 70 HKD, then you will earn 20,000 HKD (70 HKD - 50 HKD = 20 HKD x 1,000 shares = 20,000 HKD) as profits, less the administrative fees and commissions owned by your broker or exchange. On the contrary, if the share price declines to 30 HKD, you will lose 20,000 HKD (50 HKD - 30 HKD = 20 HKD x 1,000 shares = 20,000 HKD) instead.
Why is Futures popular?
Futures are a useful vehicle for hedging market risks. In simple terms, most traders nowadays are trading futures to reduce their risks, as trading them has the following advantages over the other common financial instruments.
1. Amazing tool for hedging risks
Companies can hedge the price of the products they sell or foreign exchange rates to secure against adverse price or rate movements.
There are various risks existing in the market, and futures are an essential tool for managing such market risks. For instance, the fluctuations in the foreign exchange ratio are a torment for companies engaged in international trade.
This is exactly where futures can come into play. Buyers can lock in a foreign exchange ratio by entering into a futures contract with the counterparty, if they expect a drop in the exchange rate in the near future when they pay their sellers.
2. Earning fast money by speculation
The benefits of futures are not limited to companies, because individual investors can also use futures contracts to speculate on the price movement of the underlying asset.
Since the futures are often traded on a leverage ratio which depends on the contract (e.g. 1:10, or 1:20), the leverage will act as an amplifier to magnify the investor's profits. As a result, a savvy investor may earn fast money by speculating on futures as such contracts are traded with a 10 times or higher leverage ratio.
However, trading futures with a high degree of caution is highly recommended, even for the most intelligent investor in the financial world. As a double-edged sword, the leverage will also amplify your exposure to losses.
3. More efficient and fair market
Futures contracts are traded in huge quantities every day, while the presence of buyers and sellers guarantees the placed market orders can be traded promptly.
This undoubtedly leads to an efficient futures market where most players' demands could be met swiftly. In addition, unlike trading on inside information in the stock market, doing so in the futures market is extremely difficult. The reason behind this phenomenon is quite simple: the inside information from a single company is too paltry to impact the price or rate movement of physical commodities and fiat currencies.
Can you imagine a Federal Reserve official will leak inside information to the public that the Federal Reserve will raise the rate by 75 or 50 basis points in their next meeting? The chances are very low! In short, the price movement of futures is largely determined by the whole macro-level environment, making the futures market not only efficient, but also fair.
Risks of Trading Futures
1. Leverage brings more risks
As we mentioned above, leverage is a double-edged sword, bringing both more profits and risks. The high leverage ratio often simulates irrational investors to put more bets on speculation, the common cause for big losses in trading futures. If the leverage ratio is set to 1:10, this means an investor only needs to put up 10% of the actual value of the futures contract.
More specifically, if the price of the underlying asset is 100 HKD at first and it goes down by 10%, then all the initial margin will be wiped out completely. On the contrary, if no leverage is involved in this trading, then 10% decline means the investor still holds 90% of the value of the underlying asset.
In simple terms, a relatively small drop in the price could unfortunately result in a forced liquidation of all the investor's positions, causing substantial losses.
2. Time-consuming
The trading hours in the stock market always start in the morning, and end in the afternoon, meaning the trading hours are not endless. However, the futures market is open for trading 24 hours a day, with your asset value changing incessantly.
Therefore, a lot of time dedication to watching the market movements is necessary for investors. You either spend tons of time in your daily lives if you cannot afford to lose money, or accept the potential of losing money if you would like to enjoy more personal time.
When should you buy Futures?
As we mentioned above, futures are a great tool for individuals or companies to manage risks and earn profits by speculation.
If you are confident about the future price movement of an underlying asset, it may be a good time for you to seek profits or hedge risks by entering into the futures contract.
Is Futures a good investment?
This depends on your specific demands and market circumstances. On the one hand, futures can help you hedge risks or obtain profits. On the other hand, futures may also cause you a substantial amount of losses. You are highly recommended to carefully ponder over your risk appetite and demands when purchasing futures.
What Happens if You Hold a Futures Contract Until Expiration?
The futures contracts will go into the stage of settlement, when you hold a futures contract until expiration. Generally, investors will settle the futures either through cash settlement or physical settlement.
Regarding cash settlement, the investor's account will be debited or credited depending on whether there incurs a profit or loss. As for physical settlement, the investors are required to deliver the physical assets upon the date of expiration.
Frequently Asked Questions (FAQ)
What are Futures?
- Futures are derivative contracts binding both parties to buy or sell an asset at an agreed future date and price.
Is Futures different from stocks?
Yes. Trading futures usually involve a higher leverage ratio compared with trading stocks. The possibility of trading on insider information is also lower for futures.
In summary, the potential profits and risks on futures are both higher than stocks.