The Futures Market
In short, futures contracts are agreements to buy or sell an asset on a specified future date, at a contracted price. This means you are either hedging a position you have, or speculating on the future value of a particular stock, market sector, currency or interest rate.
There are commodity based futures contracts such as oil, gold, wool and cattle, or equity futures that reflect the value of a sharemarket index. Traders can also take positions on government bonds currency pairs such as the AUD/USD.
In Australia there is one main market for futures traders, the Australian Securities Exchange. The most active of the local futures is the Share Price Index (or SPI), which is used to reflect the future value of the market’s leading benchmark, the ASX/S&P 200.
Unlike the physical stock market, futures can be traded 24 hours over the trading week, allowing investors to speculate on assets like currencies, interest rates, bonds, commodities and equities.
The purpose of trading futures contracts is either purely for speculation or for hedging against movements in a share portfolio. The futures market gives a trader the opportunity to take advantage of bearish sentiment on stocks within your portfolio, while still maintaining your current position.
If you believe that the market or a certain sector is likely to go down in value over the coming months but are prepared to ride out the downturn, you may wish to sell a futures contract which closely aligns with your share portfolio. If you are correct, the value of your portfolio will go down, but your losses will be offset by the profits you make from the sale of the futures contract.
Even if you are wrong and the market goes up, so too will the value of your portfolio and these gains will offset the losses you sustained on the futures market. This is not a perfect trading plan as your portfolio may behave differently to the contract, but it will largely have the effect of protecting your capital.
Conversely, futures can magnify bullish sentiment on stocks that you already hold. If you bought a futures contract with the view that the market was on the rise, not only would your portfolio become more valuable, but also you would reap the benefits of a futures contract, which is accumulating value. However this can also be a more dangerous position to be in as a move in the wrong direction will hurt the value of both your portfolio and your futures contract.
The power of leverage
Futures contracts are leveraged positions which mean that the face value of the contract is not what you actually pay up front.
Normally, the cost of a contract is only a small percentage of the underlying value. Therefore, when you are right, your profits are significantly higher in percentage terms because you have only outlaid a small amount of the capital to control more stock than you otherwise could have if you had bought the underlying share.
Contracts are settled in cash rather than in the shares that they represent, so at expiry, you will get the difference between the actual value of the contract and the price you bought or sold, or you will need to pay the difference.
CFDs are an excellent way to speculate and hedge. However, as with any leveraged product, they can magnify profits but of course also magnify losses.
That is why it is critical that you manage your capital and be disciplined with the amount you risk on any one trade. Once you have that down pat, trading futures can be a valuable tool in managing portfolio risk.
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