Futures are standardized contracts which, like options, are made between two parties at a fixed price and expiry date. It is a contract to deliver an underlying product at an agreed time in the future at an agreed price, hence the name. They are a type of derivative because the underlying product itself is not owned. Rather, it obtains its value from the price of an underlying asset. This can be an index, a financial instrument or a commodity.
How do futures work?
A futures contract is a negotiable contract that relates to the purchase (long) or sale (short) of an underlying asset. Delivery will take place in the future at an agreed-upon date and price. Buyers and sellers have opposing expectations of how the underlying’s value will materialise. A buyer will realise a gross profit when there is an increase in the value of the underlying at the closure and will realise a gross loss when the value of the underlying has decreased. Moreover, if you take a long position when trading futures contracts, you think that the underlying price will increase. Like many other derivatives, they have a contract size where each future has a fixed number of the underlying product as the underlying value.
How are futures settled?
The payment for a futures contract is made at the end of the agreed term. This can be done by physical delivery or a cash settlement. Index futures, such as FTSE futures, are usually settled in cash. With physical delivery, the specified goods are actually delivered. This, however, does not happen often since they are regularly sold before they expire. One of the top reasons for investing in this type of financial product is to make a profit by taking advantage of price differences in the underlying securities. Therefore, cash settlement is more common than physical delivery. There is no flow of money with buying and selling. The agreed price must only be paid upon delivery. However, a broker will require a down payment because of the large commitment that has been made.
Say you think a stock index will go up. It is at 600 points, and you consider a futures contract with a contract size of 200. The value of this futures contract would be €120,000. When trading futures, you do not pay this whole amount at the time of purchase, but typically put down an initial margin to enter into the contract. Say there is a margin rate of 15%. You would get a €120,000 exposure to the underlying by making a deposit of at least €18,000 as margin to your account. This means you can get a large exposure for a small initial margin with a futures contract. If the index would go down and your margin becomes less than 15%, you will receive a margin call, asking you to increase it above the 15% threshold.
Unlike options, futures are settled on a daily basis. This means that if the future has gained 3 points at the end of the trading day, you will receive 3 times the €200 multiplier, for an amount of €600. Do note that because the contract size is bigger than the margin, it is also possible to lose more than your deposit with futures.
Futures and hedging
Futures are a common derivative used to hedge risk. Companies and investors use them to neutralise risk as much as possible. This is done by removing the uncertainty of a future price of an item or financial product. You are able to use short and long hedges. With a short hedge, one enters into a short position on the contract. They are typically initiated by traders who own an asset and are worried about prices declining before the sales fate. On the other hand, a long hedge occurs when one enters into a long position. For example, if a company knows it needs to purchase a particular item on a future date, and the current spot price is higher than the future price, they can lock in the lower price. This removes the uncertainty off the future price of a product.
Costs and margin involved with trading in futures
DEGIRO charges connection fees, transaction costs and settlement costs for trading in futures. You can find these costs in the cost overview. You only pay settlement costs at the final settlement upon expiration, not before.
As previously stated, a broker requires collateral for the commitment that has been made. This reserved amount is called the initial margin. Given the high risk, this can be a considerably high amount. DEGIRO created a risk model, which is used to determine the amount of collateral required. In case the price of the underlying asset differs from what you have expected, you can often meet your obligation with this reserved amount.
How can you invest in futures with DEGIRO?
At DEGIRO, you can trade in futures on a number of affiliated derivatives exchanges. Due to their relatively high risk and their complexity, they are not suitable for inexperienced investors. Therefore, with a DEGIRO account, you cannot directly trade in derivatives. You will need an Active or Trader account, which comes with additional appropriateness tests and terms and conditions.
Trading in derivatives, such as futures, can be very profitable, but it comes with substantial risk. On the upside, you can profit from the leverage effect, which allows you to achieve a high return on your investment. On the downside, however, you can lose more money than your initial stake. Futures are complex financial products. At DEGIRO, we are open and transparent about the risks that are related to investing. We do not facilitate the settlement of physically delivered contracts. We inform customers about an upcoming expiry and request the position to be closed on time. If that does not happen, DEGIRO closes the position for the investor to prevent, for example, having to buy a number of barrels of oil. We, therefore, ask for collateral. In some exceptional situations, the losses an investor experiences can be higher than this collateral. If you have insufficient collateral according to our risk model, we can ask you to make a deposit or to lower your risk. If you do not solve the deficit in time or if your risk becomes too high according to the model, DEGIRO can intervene. It is recommended to only enter into obligations that you can meet with money that you do not need in the short term. You can find more information about buying futures on this page.
The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
Introduction
As an expert in the field of futures trading, I can provide you with a comprehensive understanding of the concepts mentioned in the article you shared. I have a deep knowledge of the workings of futures contracts, including how they are traded, settled, and used for hedging purposes. I will explain these concepts in a clear and concise manner, ensuring that you have a solid grasp of the topic.
Futures Contracts
Futures contracts are standardized agreements between two parties to buy or sell an underlying asset at a predetermined price and date in the future. They are similar to options contracts in this regard. However, unlike options, futures contracts require both parties to fulfill the contract at the agreed-upon date.
The underlying asset of a futures contract can be an index, a financial instrument, or a commodity. The value of the futures contract is derived from the price of this underlying asset. It's important to note that futures contracts are considered derivatives because the underlying asset itself is not owned by the parties involved.
How Futures Work
A futures contract allows traders to take either a long or short position on the underlying asset. A long position is taken when a trader believes that the price of the underlying asset will increase, while a short position is taken when a trader expects the price to decrease.
At the end of the trading day, futures contracts are settled on a daily basis. If the value of the future has increased, the buyer will receive a gross profit, and if the value has decreased, the buyer will experience a gross loss. Settlement can be done through physical delivery of the underlying asset or through cash settlement, depending on the type of futures contract.
Settlement of Futures Contracts
Futures contracts can be settled through physical delivery or cash settlement. Physical delivery involves the actual delivery of the specified goods. However, in practice, physical delivery is not common as most contracts are sold before they expire. Cash settlement, on the other hand, is more prevalent. In cash settlement, the difference between the contract price and the market price is settled in cash.
Margin and Leverage
When trading futures contracts, traders are required to provide an initial margin, which is a percentage of the contract value. This initial margin serves as collateral and is deposited with the broker. It allows traders to have a large exposure to the underlying asset with a relatively small initial investment.
Leverage is a key feature of futures trading. It allows traders to control a larger position in the market with a smaller amount of capital. However, it's important to note that leverage can amplify both profits and losses. If the market moves against a trader's position and their margin falls below a certain threshold, they may receive a margin call, requiring them to increase their margin to maintain the position.
Hedging with Futures
Futures contracts are commonly used as a hedging tool to manage risk. Companies and investors use futures contracts to mitigate the uncertainty of future prices for items or financial products. A short hedge involves entering into a short position on a futures contract to protect against declining prices. On the other hand, a long hedge is used to lock in a lower price for a future purchase when the current spot price is higher.
Risks and Costs
Trading futures contracts involves risks and costs. Brokers may charge connection fees, transaction costs, and settlement costs for trading in futures. Additionally, traders are required to provide collateral in the form of an initial margin. The amount of collateral required is determined by a risk model created by the broker.
It's important to note that futures trading carries substantial risk, and it may not be suitable for inexperienced investors. Losses can exceed the initial investment, and traders should only enter into obligations that they can meet with funds they do not need in the short term.
Conclusion
Futures contracts are an important financial instrument used for trading, hedging, and managing risk. They provide traders with the opportunity to profit from price movements in various underlying assets. However, it's crucial to understand the risks involved and to have a solid understanding of the market before engaging in futures trading.
Please note that the information provided is for educational purposes only and should not be considered as financial advice. It's always recommended to consult with a qualified financial professional before making any investment decisions.
I hope this explanation has provided you with a clear understanding of the concepts mentioned in the article. If you have any further questions, feel free to ask!
