Futures and forward contracts – overview

Futures contracts are a type of futures contracts and a transaction in which one party agrees to sell a fixed amount of an underlying instrument for a precise price at a precise time. It is worth knowing what the characteristics of futures and forward contracts are and how to invest in them.

What are futures and forward contracts?

Futures contracts are derivatives, which means that they mimic the price of an underlying asset, such as indices or stocks. An investor “bets” with other market participants on what the price of a specific asset will look like in a few months.

When an investor decides to buy a futures contract, he or she is betting that the price of the underlying asset will rise. A seller of a futures contact, on the other hand, is betting that the price will fall. Profit will be generated by the party that correctly predicted the direction of exchange rate changes.

The futures contract will be settled on the agreed execution date. However, it is possible to close the position earlier. To do this, you need to execute an opposite transaction. What does this mean? If the trader took a short position, he must buy a futures contract with the same parameters. When the trader took a long position, he must sell the contract to complete the transaction.

The basic form of a futures contract is the same as forward contracts. However, the difference is that futures contracts are a standardized product that is concluded through an intermediary – either on exchanges or at clearing houses. Forward contracts, on the other hand, are concluded on the OTC market, directly between counterparties. In the case of a futures contract, there is little credit risk, despite the likelihood that the counterparty will default on the contract, because the parties to the transaction maintain margins.

A large proportion of futures contacts are settled in cash. Only a few percent of contracts are settled by delivery of the underlying assets. The possible uses of this type of instrument are as follows:

• Arbitrage – taking advantage of a temporary imbalance in the market to realize a risk-free profit,
• Hedging – hedging the value of either a planned or current portfolio,
• Speculation – opening in the derivatives market to realize a profit,

The price of a futures contract is approaching the spot price as the time to execute the contract shortens. This is the effect of the market and the economic thinking of traders. The price of a futures contract information about the market’s expectation of how the spot price will develop at a certain time, what delivery date in a given futures contract.

Futures contract pricing formula

Depending on the type of contract and anticipated events, its valuation formula can vary, but the basic formula looks like this: F = S x (1+ r x t), where:

F = forward price,
S = present value of the underlying instrument,
r – risk-free interest rate on an annual basis,
t – time to expiration of the futures contract in years.

What are the characteristics of futures contracts?

The characteristics of these contracts are:

• their price is set by the stock market order of investors,
• they are listed on the stock exchange,
• they are standardized in terms of the type and size of the commodity and the size of the contract and the date of execution, as well as the method of settlement, as well as the place and time of trading,
• there is no actual delivery of the commodity in them.

Futures contract vs. underlying instruments

A futures contract is a derivative instrument. This is because the price of a particular contract depends on the price of the underlying instrument on which it is based. Underlying instruments include, for example:

• stock market indices,
• publicly traded companies,
• interest rates,
• currencies,
• government bonds.

Types of financial futures contracts

The largest group of futures contracts are financial futures contracts. Based on the type of the underlying instrument, they can be divided into 3 groups:

• Currency futures – their object is currencies,
• Interest rate futures – their object is interest-bearing financial instruments,
• Index futures – their object is economic indices.

As for currency futures, they are considered the oldest forms of such transactions, but despite this, their share worldwide is not large. The subject of currency transactions are the currencies of the most developed countries, i.e. the Canadian dollar, the US dollar, the pound, the euro, the franc, the yen, etc. In this type of transactions, currency prices are on determined in U.S. dollars per unit of another currency, in turn, the dollar itself must be shown in another currency.

In the case of interest rate futures, the object of the transaction is securities, as well as bank deposits, which have a fixed interest rate. There can be short-term money market instruments, as well as long- and medium-term capital market instruments. These include, for example, treasury bills, certificates of deposit, bank deposits and bonds.

Index futures, on the other hand, are considered a relatively young group of futures contracts. Usually the subjects are stock market indexes, but also other economic indexes, such as bond rates, foreign exchange, services and commodity den (read also: Online stock market). These types of transactions have their own distinctive feature, that is, they do not allow physical delivery of the subject of the transaction.

Parties to a futures contract

Futures contracts are concluded between two parties to the transaction and they are:

• The seller, who counts on an increase in the price of the underlying instrument,
• The buyer, who counts on a decrease in the price of the underlying.

Margin and leverage

However, futures wouldn’t be so popular if they didn’t offer the possibility of making money much faster than trading stocks. Such an option is made possible by leverage. For example, when the price rises from USD 200 to USD 210, having shares of this company, the trader gains 5%. When it comes to futures contracts on these securities, the profit can be much higher.

This is made possible by leverage, which increases the value of the trader’s deposit. In addition, when the trader feels that the price of the shares of a certain company will fall, he can also earn from this. However, it is important to remember that leverage is a double-edged sword and can also magnify losses.
Associated with futures contracts is the need for proper margin.

In Example on the Warsaw Stock Exchange, the amount of margin needed is determined by the NDS. The security deposits are usually relatively high, such as 40 thousand zlotys. Therefore, futures contracts are instruments that are used more often by investment funds than individual investors. However, thanks to leverage, the margin can be reduced, for example, from 40 thousand zlotys to 4 thousand zlotys.

Long and short positions

Futures contracts are a contract that deals with a future obligation, so anyone can either buy or sell. Buying a contract is called opening a long position, while selling is opening a short position. The party buying the contract cares about the price going up, because then his actions will result in a profit. The selling party, on the other hand, cares that the price goes down, because that is when he makes a profit.

Closing a position

In order to close the contract before its expiration date, you need to make a reverse transaction in the same amount. The buying side, i.e. the holder of a long position, should sell the contract, while the selling side, i.e. the holder of a short position, must buy the contract.

Positions are also closed automatically on the day the contracts expire. In this case, there is an automatic cash settlement between holders of long and short positions. On the Stock Exchange, there is no physical settlement of the settlement of contracts – it is the actual delivery of the object of the contract, e.g. currency, shares, etc. In the global markets, the large majority of contracts are settled in cash. A small part, especially agricultural or commodity contracts, is linked to physical delivery.

Daily settlements

Unlike the stock markets, where a trader does not have to expect to spend cash, the futures settlement process looks a little different. In this case, the mechanism of daily profit and loss settlement, or mark-to-market, works. Taking the daily settlement price, usually the closing price, the losses and profits of all holders of short and long positions are calculated. As for losses, they are taken from the margin. This happens up to a certain limit threshold.

If the loss is related to a drop below this threshold, the party holding the contract must add cash and top up the margin to the initial value. If he is unable to do so, his position is instantly closed.

Expiration and series of contracts

Each contract for a specific instrument is traded in series, and this means that they differ in their expiration dates. The expiration dates are determined by the exchange. The rule of thumb is that the most active trading is done on the contracts that have the closest expiration date, but before the final date the next series is traded.

Futures and cash prices

When it comes to futures contracts, the price depends on the underlying instrument, but can vary from it. The longer the time to expiration of the contract, the greater the difference can be. Depending on the type of contract, whether it is for an index, stock, currency or raw materials, its theoretical value will take into account the cost of money, dividends, interest rates or storage costs (read also: How to make money in stocks and Basics of investing in the stock market).

As for practice, actual contract prices may differ from the theoretical valuation for various reasons. Differences in valuations are often exploited by various market participants, who count on the fact that even if these differences are not corrected, on the day the contract expires, its price will equal the price of the underlying instrument.

Futures contracts – types

The basic division of futures contracts is:

• Futures contracts – are contacts that are established with the help of an exchange, such as the Warsaw Stock Exchange,
• Forward contracts – are over-the-counter contracts.

It is also possible to divide by the underlying instruments on which the futures contracts are based:

• Stock futures – and in this case the financial instrument is stocks,
• Index futures contracts – these can be either stock market indexes or sector indexes,
• Commodity futures contracts – these are not used on the WSE. They are available on trading platforms, and the underlying instrument is commodities, which are traded on the US CME exchange,
• Currency futures – the underlying instrument is the exchange rate.

What is the difference between futures contracts and CFDs?

Futures contracts are very often equated with CFDs, or contracts for difference (read: Best CFD broker and CFD trading) . Although these two types of derivatives are similar, they should not be treated in this way. What similarities do they have?

• They are derivatives, that is, based on underlying instruments, e.g. stocks, commodities (read: How much money can you make from stocks),
• Both the former and the latter use leverage,
• Both short and long sales are possible, i.e. playing for declines as well as increases.

In turn, the differences between these types of contracts are:

• Futures contracts are traded on a regulated exchange, while CFDs are over-the-counter instruments,
• Futures contracts can affect the supply and demand on a particular exchange, i.e. affect the valuation of certain assets. Traders often suggest the direction that futures contracts take. CFDs, on the other hand, do not influence the market in any way, as they trade exclusively with their broker,
• Futures contracts require a higher deposit than CFDs,
• With CFDs, you pay to hold your position, while when it comes to futures contracts, swaps are not charged,
• Futures contracts have their own expiration time and cannot be automatically extended. As for CFDs, it is possible.

Read also: How to invest in silver

Rules for using futures contracts

Here are the rules to follow when deciding to invest in futures contracts:

• Hedging against the risk of a decline in the underlying instrument by selling a futures contact that is exposed to the underlying instrument,
• Using contacts to speculate, i.e. buying a contract is done by waiting for the price of the underlying instrument for which the contract is issued to rise, or selling a contact is done by waiting for the price of the underlying instrument for which the contract is issued to fall.

Course and value of the contract

An important issue for the trader is the price and the value of the contract. It is important to remember that these will not give the same values, as in the case of stocks. The amount of money a trader must have to buy a contract is derived from the price, the multiplier, and the margin.

Stock futures contracts

In the case of stock futures contacts, the parties involved must transact in the stock of a specific company, at a predetermined price and a specific day. The price of the contract is determined by the spot price of the underlying stock. Unlike options, both the buyer and seller are obliged to transfer the underlying shares.

Stock futures allow investors to speculate on the future price of a specific stock. In the futures market, both buyers and sellers have opposing beliefs about how the value of the underlying stock will develop. A buyer of a stock contract will make a gross profit if the value of the underlying instrument rises at expiration of the futures contract, and in turn make a gross loss if it falls. And the seller will make a gross profit when the value of the underlying instrument falls at expiration, and a gross loss if it rises.

How do stock futures contracts work?

Unlike other products, in this case the trader does not pay the full amount upfront, nor does he own the underlying asset. However, he must deposit an initial margin, so he can enter a stock futures position. As for the required margin amount, it is a percentage of the contract value.

A stock futures contract has a notional value, and to find it, one must multiply the price of the underlying stock and the contract size. The contract size is the possible number of underlying shares that is represented in each contract. Often one contract contains 100 underlying shares.

If a trader is unsure about the size of a contact, as well as the maturity date, he can check the exchange’s website for the specifications of a particular contract. This information is, in most cases, very readily available. Other information that relates to the characteristics and risks of the product can be found in the document that contains the key information. Moreover, the risk category of stock futures can be found behind the product name.

Usually only a percentage of the contract value needs to be delivered initially, and stock futures are highly leveraged instruments. This means that small price changes can significantly affect them. When the margin requirement is higher, the trader usually has to deposit more margin, allowing him to enter a position on the futures contract. The result is lower leverage.

Read also: How to invest on Plus500

Futures contracts are characterized by a minimum price increment to which a specific contract can fluctuate, called tick size. This is specified in the specifications of the contract, which is determined by the exchange. However, on the other hand, the year’s value is the actual amount of money that is gained or lost on a futures contract for a tick movement, and is equal to the tick size, which is multiplied by the contract size.

How to start investing in futures contracts?

To start investing in futures and other contracts, the first thing you need to do is either open an investment account or sign an addendum to your current contract with a brokerage house. In the first case, the investor will be required to pass a knowledge test on futures contracts. If he does not give the correct answers, it may result in a refusal and inability to invest in futures contracts.

Read also: How to invest small amounts of money

These financial instruments are associated with a higher degree of risk, which is why brokers use this type of security. In addition to futures contracts on the WSE, some brokerages also give the opportunity to trade in foreign contracts.

Futures contracts – risk

Derivatives are characterized by high investment risk. Of course, it is possible to obtain high profits, but also high losses. In very unfavorable circumstances, the amount of losses incurred may exceed the value of the money that was deposited as a deposit. If the value of the margin falls below the required level, the client will be called upon to replenish it.

If he fails to do so within the prescribed period, some or all of the open positions may be closed by the entity that is responsible for settling the investor’s obligations, but the client is not relieved of the obligation to cover in full the resulting liability. Requiring a deposit of less than the theoretical value of the derivative results in the creation of leverage.

Forward contracts – what are they?

Forward is a transaction in which the parties agree to mutually exchange 2 currencies at a fixed point in the future. The exchange rate is determined at the time of the transaction and depends on 3 factors:

• The current market rate,
• The difference in interest rates between the currencies involved in the currency conversion,
• The period for which the transaction is concluded.

Companies wishing to enter into forward contracts are required to maintain a deposit in a bank account as collateral for the execution of the transaction.
Settlement can be made in 2 ways:

• By actual delivery, in which case the parties exchange agreed amounts of currency,
• By net settlement – this is a settlement as to the value that results from the difference between the TTW rate and the current rate on the settlement date.

As for forward contracts, there are no additional costs associated with them. Banking institutions do not charge any commission on this account. Moreover, during the life of the contract, the customer has the right to change its expiration date. This is equivalent to a change in the execution rate, and has the same effect as if the customer had immediately entered into a transaction for a shorter or longer period of time. The new contract price is determined by changing only one variable in the pricing formula, namely the number of days.

These contracts are traded on regulated exchanges around the world, recognizing them as over-the-counter transactions. This is because in the forex currency market there is no central trading location (read: Forex investments). Transactions can take place between two entities using online trading platforms and sometimes even with a phone call anywhere in the world.

Read also: Forex strategies

Futures contracts – risks

Some of the risks associated with investments in futures contracts are associated with other financial instruments, viz:

• the risk of future price development,
• risk of suspension of trading or exclusion of the financial instrument from trading,
• risk of liquidity of the financial instrument.

When it comes to investing in futures contracts, there are still associated:

• Volatility risk – the volatility of futures contracts can be much higher than the volatility of the underlying,
• Base risk – in this case, the price of the derivative may deviate from the theoretical value, which is derived from the valuation of the underlying instrument,
• Underlying risk – results from the risks that relate to the financial instrument whose quotes are the basis for either valuation or settlement of the futures contract,
• Dividend risk – when it comes to a financial instrument that is based on stock quotes or price indexes, payments of such index components have a negative impact on the valuation of the underlying instrument and, as a result, the futures contract on a specific index. As for changes in expectations of dividend payments, the price of the contract can change significantly,
• Rollover risk – the need to take the same position on the next series of a contract of the same type as the one held, due to the near expiration of the futures contract,
• Leverage risk – it only takes a fraction of the value of the actual transaction that has been taken as collateral to make a deal, and this creates leverage.

How to invest in futures contracts?

In order to invest effectively, regardless of the choice of market and financial instruments, it is worth applying some universal principles:

• Diversification of the investment portfolio – it consists in the fact that the investor invests his capital in various assets, not just one. This way, if the price of a particular financial instrument falls, he will protect part of his capital, which is spread in other assets,
• Cool calculation – when deciding to invest in futures or other financial instruments, it is best to approach it without emotion. This is not an easy task, but it will make investments more successful. Acting under stress or excitement is not appropriate. Professionals are able to eliminate emotions and approach making transactions coolly. This allows them to make appropriate investments and close deals to limit losses,
• Continuous expansion of knowledge – investing involves continuous learning. When deciding on this occupation, it is worth keeping this in mind as well, since it is necessary to keep abreast of all stock market news. It is worthwhile to take advantage of training and courses, which are available both online and stationary. You can also gain knowledge from webinars, as well as articles that can be found on the Internet (read also: Stock market investments for beginners),
• Acceptance of investment risk – it is important to remember that investing is inextricably linked to risk. In order to play the stock market successfully, an investor must understand and accept this. It may happen that an investor loses all his capital and should be mentally prepared for this,
• Investing in futures or other financial instruments exactly how much can be lost. If the person investing the money is needed for other important expenses, such as current fees, bills or car repairs, it should not be used to make investments. Also, one should not borrow from family, friends, and even less from loan companies in order to have money to invest,
• Invest only in those financial instruments about which you have some idea. Do not invest funds in assets that you do not know. As you gain knowledge and experience, you can also invest in other financial instruments,
• Investing according to a plan – before you start investing, you should choose a suitable investment strategy. You can use ready-made strategies that are available on the Internet, or you can create your own, relying on ready-made ones and drawing from them the elements that suit the investor best. It is worth sticking to the chosen strategy and not changing it after a few unsuccessful trades.

Summary

Futures contracts are financial instruments that are recommended for people who already have some investment experience. If an investor has not traded stocks before, he should start with this step, so that he can become familiar with the capital market.

Futures contracts are associated with high risk, due to the use of leverage, as well as the need for a high margin. It’s worth remembering that when the underlying’s exchange rate movements don’t go the trader’s way, he often has to put in extra money to avoid being thrown out of the position.

Futures can help during a prolonged stagnation in indices or a bull market, because of the ability to gamble on declines. The typical stock market does not allow you to take such steps, because you only make money when the valuation of securities increases.