Forwards and futures are financial derivatives that use the same concept. Instead of trading an asset now- you trade it later! Forwards and futures state the number of assets traded, the transaction price (known as the forward price or future price), and the date of transaction (known as the delivery date or expiration date). The forward and future price may differ from the asset's current market price (the market price is also known as the spot price).
It sounds like options, doesn’t it? That’s because it’s using the same concept of setting a price for a transaction in the future. The difference here is that while an option gives the buyer of the option the right to choose whether to exercise it or not, for forwards and futures, it is an obligation instead. You must settle the contract when the delivery date arrives. Options also come with a premium attached to them, while forwards and futures don’t.
So what’s the difference between forwards and futures?
Forwards are private contracts that are settled over-the-counter between two (or more) parties who will agree on the contract terms, such as the delivery date and price.
On the other hand, futures are settled on exchanges between investors and other market participants. The terms of futures (i.e. the futures price, the expiry date, and the underlying assets) are fixed and standardised.
As an investor, futures are more relevant to you as they are readily available on exchanges with standardised terms. You wouldn’t want to be bogged down by written agreements and the contract dealings of forwards, would you? Still, it was necessary to be forward-looking and understand forwards as well!
For now, let’s go back to the futures.
There are two types of futures contracts. They can be cash-settled or settled through physical delivery.
Cash-settled futures contracts are more common for those with financial instruments as underlying assets. They are settled purely by cash, taking the difference between the futures and spot prices of the underlying asset on the expiration date. Notice that the underlying asset is not physically traded in this case.
Physical delivery futures contracts are mostly used for those with commodities or other physical assets as the underlying. The asset will be transferred to you on the expiration date while you pay the futures price.
You have to be careful regarding which futures contract you’re trading in. If you’re using futures for short-term gains and not securing the underlying, trade in the cash-settled futures market. You may not want 100 barrels of crude oil arriving at your doorstep!
Fret not, though, as even for physical delivery futures, less than 5% of them result in actual delivery! Typically, the underlying assets will be stored in an exchange-designated warehouse, where you can leave them stored for a fee before you sell them off afterwards (either through another futures contract or in the spot market*)
*The spot market simply refers to the current market. If you sell something on the spot market, the transaction is happening now and not in the future.
There are many different underlying assets traded as futures in the market. Common examples include:
Like most financial instruments traded on exchanges, you may enter either a long or short position when trading futures.
Long position: enter this position if you expect the price of the futures contract or the price of the underlying asset to rise.
Short position: enter this position if you expect the price of the futures contract or the price of the underlying asset to fall.
At any point, if you want to rid yourself of the obligation in the futures contract, you can enter an offsetting position. An offsetting position involves buying the opposite position of the same futures contract (e.g. if you have a long position in futures, open a short position in the same contract). This ensures that your obligation in one contract is entirely settled by the obligation in another, so you don’t need to worry when the expiry date arrives!
Your futures contracts will be settled daily. At the end of every trading day, the futures price will face a mark-to-market, and your contract will be settled; i.e. you will receive any profit or pay any loss that has occurred at the end of the day. This will happen every day until the expiry date. This is opposed to most other financial instruments, which are only settled once when the position is closed.
As the futures contract nears its expiry date, the futures price will approach and eventually reach the spot price. So if you had held the futures to the expiry date, your overall profit/loss would always equal the difference between the futures price you bought and the spot price on the expiry date.
For example, you buy wheat futures at a futures price of $6.50 a bushel, and the expiry date is 3 days away:
Hence, a daily settlement does not affect your overall profit or loss, but it does make you realise your gains and losses daily. As futures are leveraged instruments, it will also help your broker keep track of your margin account to ensure that your position does not fall below the maintenance margin requirement.
Like CFDs and some options, futures are typically sold on margin. This means that you’ll be borrowing money from the broker to increase the size of your initial investment. If the leverage is 20:1 (may also be stated as a margin requirement of 5%), this means that for every $1 you put in, you’re borrowing $19 to buy $20 worth of futures contracts. This is a way of maximising returns and losses in your investment!
If you’re expecting a share price to plummet, a short position in a single stock future (SSF) is one of the various ways to profit from the fall of a share price.
Short selling a share directly is expressly hard to do in Singapore due to various regulations (particularly but not only around borrowing said share). As such, using derivatives such as futures and CFDs can be a good way to take an indirect short position in shares.
Futures are a popular way to hedge, both for producers and end-users of commodities and those with financial market exposure. Futures, both cash-settled and physical delivery ones, may secure the prices you’re selling or buying the underlying assets in the future (on the expiry date).
Futures protect you from the price volatility in the spot market (i.e. you know what price you will get, which helps with real-life planning. It's not about trying to profit from rising prices if you're a producer or falling prices if you are a buyer).
For example, David is a farmer who sells wheat, and he wants to lock in a price of $6.50 per bushel for his harvest in July. He takes a short position in a wheat futures contract with a futures price of $6.50 for the quantity of wheat he plans to sell. This means that he must deliver the wheat and receive $6.50 for each bushel when the expiry date arrives.
Let’s say that the spot price of wheat climbs to $6.60 per bushel at the expiry date in July. David will generate a loss on his futures position of $0.10 per bushel (see image below) when his futures contract expires*, but he will sell his wheat on the spot market for $6.60 per bushel. This brings his net selling price to (ta-daa!) $6.50 per bushel.
If the spot price is $6.45 on the expiry date instead, David will have made a gain of $0.05 per bushel from the futures contract (see image below). He will sell his wheat in the spot market for $6.45, making his net selling price $6.50 per bushel.
On the flip side, if you are the buyer of the commodity and not the producer like in the example above, you will take a long position in the appropriate futures instead! The mechanism works the same way, and you’ll be able to lock in your purchase price for the future.
*For a cash-settled futures contract, you will receive your gains or pay your losses when the contracts expire. You are obligated to deliver the wheat to the exchange-designated warehouse for a physical delivery contract.
However, as a producer, there is a high chance that you already have a regular buyer whom you will deliver to. As such, you will sell your wheat to your frequent buyer at the spot price. Then, you will offset your futures contract obligation by buying wheat at the spot price on the exchange (the wheat is already at the warehouse).
With higher returns come higher risks. While margin trading magnifies your earnings, it also magnifies your losses if the market swings the wrong way. You can lose your entire investment with just a small percentage drop in the underlying asset’s price. If you get a margin call and put in more money to prevent the brokerage from forcibly closing your position, you may lose more than your initial investment!
Not all brokerages will have access to the futures markets. Also, not all futures markets will have futures for all possible underlying assets.
Unlike options, the purchase of futures comes with an obligation to buy or sell the underlying asset at the expiry date. Hence, there is no capping of liability. If you are in a loss-making position (e.g. you entered a long position in oil futures, but the spot price is lower than the futures price on the expiry date), that loss-making position will be realised, and your payoff will be negative.
For example, you are in a long position in a futures contract for 100 barrels of crude oil at a futures price of $72 per barrel. However, supply has suddenly increased, and the spot price of crude has fallen to $70 per barrel on the expiry date.
Due to your obligation in the futures contract, you are still required to purchase 100 barrels of crude oil at $72 each from the other party, creating a loss of $2 per barrel (vs the current market price at which you could sell it). If the contract was cash-settled, you simply lose $200 from your account. (If the contract were for physical delivery, you would receive the crude oil barrels.)
Like other financial derivatives, trading futures can be a high-risk investment strategy that can cause you to lose all of your initial investment. While the possible gains may be high, you must also consider equally high potential losses. If you’re having trouble deciding if trading futures is for you, consider asking an expert!
FUTURES. COMPLETED. ✅
Sources:
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