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UNDERSTANDING THE FUTURES MARKETS

A guide to getting started in futures

GUY BOWER

What Are Futures?


To many people futures trading is considered a risky endeavour and only for the brave hearted amongst us. This is untrue. Futures trading can be a very rewarding form of investment, but only when approached with the right attitude and strategy. The legal definition of a futures contract is a legally binding agreement to buy or sell a specified amount of a commodity or financial instrument at a fixed price sometime in the future. The original purpose of futures contracts was to provide a facility for people to hedge their price risk. Example Through the Sydney Futures Exchange you can buy or sell futures contracts based on the ASX200 Index (the SPI), the top 200 stocks in Australia. At no point are you buying or selling the actual stocks, rather you are entering into an agreement to buy or sell a dollar value based on the ASX200 index value. The contract represents $25 multiplied by the quoted index value. In Australia, the SPI is a popular market for day-trading given a reasonable tick value ($25) and intraday volatility. Futures are used by fund managers and private individuals to hedge share portfolios. However the majority of private individuals using this market are short-term traders.

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Guy Bower

Propex Derivatives Pty Ltd 2012

Many readers will be familiar with the concept of going long. Going long simply means to have purchased the asset with the view of that asset increasing in price. When you buy shares you are said to be long shares. Thats a straightforward concept. The concept of going short creates some confusion amongst new traders, however the concept is not that difficult. Gong short simply means to have sold the contract before you buy it with a view on making a profit from a fall in the price. Since futures contracts do not involve immediate delivery or settlement of the instrument, it is possible to sell the contract without first owning it. A futures contract is just an agreement, not a physical asset. So selling the contract (going short) is just an agreement to sell the underlying asset at a certain price. Buying back the short contract or selling the long contract to take a profit/loss is referred to as closing the position.

What futures contracts are available?


Pretty much any commonly traded commodity or financial asset will most likely have a corresponding futures contract listed somewhere in the world. There are futures contracts on financial assets such as individual stocks, stock market indices and short and long term interest rates. There are futures on physical commodities such as wool, wheat, gold, soybeans, lead and oil. There are even futures contracts on more obscure things such as electricity supplies, unleaded petrol and weather temperatures in certain cities. The list really does go on and on. A futures exchange will list certain futures contracts based on demand from the traders and investors. Most futures exchanges started out offering commodity-based contracts for producers to hedge price exposure. Today, hedging activity is just a small fraction of the volume of trades. Instead, speculators dominate most markets.

Elements of a Futures Contract


Underlying Asset In the above example, the underlying asset (or just underlying) was the ASX200 Index. Each tick movement in the ASX200 is worth $25. Each futures contract is different. For commodities futures, the contract will be based on a certain physical volume or a specific grade. Gold futures, for example, are based on 100 Troy ounces per contract at a grade of not less than 0.995 fineness. As mentioned each contract is different. Naturally, the quantity and any particular grading of the underlying is an important consideration in hedging any asset. Delivery Month Futures contracts have a finite life. All futures contracts are based on a specific month of delivery. Contracts on the e-mini S&P for example are listed for March, June, September and
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December for any year. An exchange will make available a number of delivery month contracts depending on demand and these will each have their own prices. Monthly Crude Oil Prices as at 16th December 2011

The concept of delivery can be a little misleading, as some futures contracts are not deliverable (see Settlement Type). For those contracts that are deliverable, such delivery rarely takes place these days. Instead most traders, investors and even hedgers will close out the futures position before it comes time to deliver, thereby relinquishing any obligations to make or take delivery. When trading a deliverable contract that is nearing expiry, ask your broker when is the best time to close your position or roll it over to the next trading month. Settlement Type (Cash or Physical) Some contracts require physical delivery of the underlying. Gold for example is deliverable in this sense. Most financial futures contracts however are cash settled, meaning only an exchange of funds takes place. Naturally, it would be very hard to deliver or take delivery of one ASX200 index. Whether a contract is cash settled or deliverable should not make too much difference to anyone who closes the position before the delivery date. Margin When buying or selling futures contracts it is not necessary to pay the full price for that contract. Rather, futures contracts require only a small percentage called a margin. An initial margin is like a deposit the trader pays when initiating a position. These funds must be in your account before you are allowed to place a trade. The margin is then held by the clearing house of the exchange and is returned when the position is closed. Typically an initial margin works out to be a few per cent of the total contract value.
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Another type of margin is a variation margin. At the end of each trading day, the clearing house from any particular futures exchange will settle all profits and losses on all open positions and credit/debit all trading accounts accordingly. Note that the positions are not closed. It is just the profit or loss that is settled. For those readers that have traded equity options, this type of margin is very similar. Exchange listing Trading of futures contracts is conducted on a futures exchange such as the Australian Securities Exchange, the Chicago Board of Trade or Eurex. Some exchanges offer electronic trading only. Others offer a pit or floor trading session. Pit trading is also called open outcry. This is the traditional system of trading futures. The contracts are traded by brokers and traders face to face in the exchange itself (the movie Trading Places has a good example). In recent years, there has been a push towards electronic trading. Some exchanges such as Eurex and Australias ASX are completely electronic. That is there is no open outcry trading floor. Some exchanges, mostly American ones, persist with open outcry trading and some offer side by side trading simultaneous open outcry and electronic sessions. While it has made a lot of floor traders obsolete, electronic trading is meant to offer a more efficient price mechanism and thereby offer a fairer system to all participants. Whether a market is electronic or pit traded is not really an important point right now. You do need to know on what exchange your markets are trading. Knowledge of different markets comes with time, but these things are also pretty easy to Google. Price Last but not least there is the price you can trade the contract. For any one futures contract, the above features are fixed and cannot be changed in the open market place. The price for any futures contract however is determined by supply and demand. The price is the only variable.

The mechanics of futures trading


Futures contracts, like shares, are traded through a broker. You have to use a futures broker, not a stock broker. Through any futures broker, you can trade any registered futures contract in the world whether it is gold in New York or share futures in London or the Nikkei from Singapore. For high frequency day trading, it is very important to have a good internet connection and an online trading platform. Thankfully, gone are the days of having to use the phone to call a broker to day trade. Many brokers these days offer some sort of online connectivity but its important to note not all are the same. Later in this course, we will cover this topic a little more.

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Guy Bower

Propex Derivatives Pty Ltd 2012

Trading examples Here we are going to learn two strategies: going long and going short. Going Long If you have traded or invested in anything before, you are already familiar with the concept of going long. This is where you buy a certain asset with the view of it increasing in price. If and when the price does increase, you can close (sell) the position at a profit. With futures contract you are not buying anything physical. You are essentially entering into an agreement to buy a certain asset on a certain date in the future. Today in the open marketplace you can agree to buy a futures contract at what the market deems to be the price. At some time in the future, perhaps later in the day, you can close out of the position by selling the contract back in the market. Lets look at the ASX200 (the SPI) futures as trading on the Australian Securities Exchange (abbreviated to ASX). In the below chart, the June SPI is trading at 4139pts. As previously mentioned, each contract is based on a dollar value of $25 times the index value.

Suppose, based on your analysis, you think the price of the index was going to rise over the next hour or so. Here you would buy or go long the contract. The process is the same as buying shares or exchange traded funds (ETFs) except of course you use a futures broker not a stock broker.

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Guy Bower

Propex Derivatives Pty Ltd 2012

So lets say you have bought one contract at 4180. Time passes and an hour later, the contract is trading at 4190. If you were to sell at this price, the trade would show a profit of 10pts (excluding commissions). In dollar terms, this translates to $250 profit per contract ($25 per point times 10pts). In this trade, you went long the SPI and it showed a nice little profit. Going Short Remember with futures, you are not actually buying the physical commodity. You are entering into an agreement based on what the market thinks that commodity will be worth at some time on the future. Any futures trade is just an agreement. In the example above, by going long you entered into an agreement to buy the June SPI contract at 4180. An hour later you sold that agreement back into the market at 4190, resulting in an overall profit of 10pts. If this is only an agreement, why cant you enter an agreement to sell instead of buy, thereby making money from a fall in the market? Well you can. This is called going short and in this case it is the opposite of going long. Lets use an example of a falling market to illustrate this. Suppose you read somewhere that the Gold price is due for a drop. In this instance, you could sell a futures contract in gold and profit from any fall in the price of Gold. This is the point where some people get stuck. How can you sell something you do not own? Remember, futures contracts are just agreements on price. There is no actual ownership of the commodity in question. So by selling a contract or going short, you have entered into a contract to sell at the current price. At any time before the expiration of the contract, you can buy it back in the open marketplace by buying one contract at the prevailing price. The chart below shows the price for April Gold futures. Suppose you go short by selling one contract at $1760. Gold futures trade on the COMEX division of the New York Mercantile Exchange. Each contract is based on 100 ounces of Gold and therefore every move of $1.00 is worth $100 per contract to the buyer or seller. Suppose later in the day, August Gold futures were trading at $1,745. To close a short position, you would enter a buy transaction. Selling one contract earlier in the day and buying it back later would leave you with no position, or flat. So lets say you did close the position at $1,745, this would result in a profit of $15 per contract or $1,500, as each dollar movement in the price of Gold is worth $100 in the futures contract. This is going short. Its a little confusing the first time you come across it, but it becomes second nature in no time.
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Links Propex main website: www.Propex.net.au Propex training site: www.PropexTraining.com

Contact Guy Bower Training Manager Guy.Bower@Propex.net.au

The information in this document and related documents and communication is intended for educational purposes only and does not constitute advice. Redistribution of the material without prior permission is prohibited. Level 4, 299 Elizabeth Street. Sydney 2000. 02 8231 3600. www.propex.net.au
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