Using Futures Correctly For Trading And Hedging

Futures, if used correctly, can be a nifty hedging tool against market volatility. Here you will learn how futures trading works.

Futures markets have their roots in agriculture, where commodities like grain and livestock were initially developed for farmers, agricultural producers and consumers to help them manage price fluctuations and other risks related to the harvesting, marketing or processing of crops. Nowadays, the futures markets have broadened along with the expansion of the world economy and a wide range of products can be traded, including currencies, interest rates, energy products like natural gas, metals like copper and stock indexes like the Straits Times Index and the Dow Jones Industrial Average.

A futures contract is an agreement on what price the investor is willing to buy or sell a specific quantity of an underlying product, say a basket of stocks or a currency, at a specific price and date in the future.

High leverage

It is important to understand that futures are highly leveraged instruments, so the potential profits and potential losses are large. Indeed, investors do not need a lot of money to buy or sell a futures contract. They only need to post a good-faith deposit, called the margin, in order to secure a contract. As the margin deposited is just a small fraction of the actual contract value, any profits and losses will be magnified. Therefore, investors should consult a licensed futures broker who can provide trading information and advise on the suitability of trading in futures.

There are two kinds of margin: initial margin and maintenance margin. The initial margin is the amount of money that must be deposited into the trading account in order to establish a futures position. The initial margin is usually set between 5% and 15% of the total value of the contract. For instance, the initial margin to buy or sell a Straits Times Index Futures contract may be $875 although the market value of this contract, trading at 1,700 index points, is $17,000 (1,700 points multiplied by $10; futures contracts are valued at 10 times the index points), so the initial margin represents only 5% of the futures value, hence the leverage is about 20 times. Exchanges set minimum margin requirements for futures contracts but individual broking firms may require higher margin deposits from their customers, depending on their risk management.

The maintenance margin is the minimum amount that must be maintained in the account when holding a position. You could realise large losses in relation to your initial investment if prices move in the opposite direction of what you anticipated, that is if you have a buy position and the price declines or a sell position and the price increases. If and when funds fall below the maintenance margin level, additional funds need to be deposited to bring the level back to the initial margin. All open positions will be marked-to-market or revalued at the end of every trading day based on the futures settlement price. Profits will be added to the account and losses will be deducted daily. Investors can withdraw their profits if there is a gain but must top up the margin in the event of a loss.

An effective Hedging Tool

Index futures can be used to minimise or manage the risk in the underlying market. For instance, an investor has a diversified portfolio of stocks and is worried about the recession, yet he does not want to dispose of the stocks. In order to protect his portfolio from adverse price movements, the investor can sell SiMSCI or STI futures contracts to hedge his stock exposure. If the stock market does turn down, the losses in the stock portfolio will be covered, or at least minimised, by profits from the index futures contracts sold earlier.

Let's say your diversified stock portfolio is worth $62,700. Anticipating that prices will fall in the near term, you can hedge your portfolio by short selling STI Futures, which is trading at 1,670 index points. The contract value will be $16,700 (1,670 points multiplied by $10). To determine how many lots of futures contracts you need to sell, divide the value of your portfolio by the value of the STI futures contract, which results in four lots ($62,700 divided by 16,700 equals 3.75).

Futures contracts can also be used as an alternative route to gain exposure to the underlying market. An investor who is bullish on the Singapore stock market can gain exposure to the broad market movement by buying SiMSCI or STI futures, hence eliminating the need for individual stock selection. On the other hand, investors who are bearish can choose to short sell the market using the SiMSCI or STI futures.

How do futures markets work?

Futures trading is carried out in organised exchanges such as The Singapore Exchange Derivatives Trading Ltd (SGX-DT), London International Financial Futures and Options Exchange (LIFFE), Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT). Associated with every futures exchange is a clearinghouse, which acts as a middleman or counter-party to every futures transaction. In effect, the clearinghouse guarantees the performance of each party to the contract, which means that it becomes the buyer to every seller and the seller to every buyer. So, investors need not worry about the financial strength and integrity of the party taking the opposite side of the contract. The exchanges also standardise the types of contracts that may be traded; it establishes contract size, contract delivery dates, how contracts are settled and so forth.

Futures contracts are traded with all bids (buying price) and offers (selling price) on each contract made public. Exchanges do not set the prices; they just provide a place where buyers and sellers can negotiate and trade. The prevailing market price of each contract is based on the laws of supply and demand. When there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. Let's take for instance the Straits Times Index (STI) Futures contract. It is traded electronically through the Electronic Trading System (ETS) at The Singapore Exchange Derivatives Trading Ltd(SGX-DT). The trading hours for STI Futures is from 8.45 am to 12.35 pm and 2.00 pm to 5.15 pm.

Buying an STI Futures contract is equivalent to buying the market value of a basket of 52 stocks represented in the index. When investors are bullish, they usually take a long (buy) position but when they are bearish, they may take a short (sell) position. Investors can liquidate the contract by making an opposite transaction. If you sold a STI Futures at 2,000 and bought the same STI Futures back at 1,950, the profit is $500 (2,000-1,950 multiplied by $10, as each futures contract is valued at $10 of the index points).