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How do futures contracts work?

Posted By Robert On Friday, February 7th, 2014 With 0 Comments

Futures contracts are a kind of derivatives class asset like spread bets and CFDs but while futures are mainly popular in the USA, CFDs are more popular in Europe and Australia.  Futures contracts can provide leverage so that a small movement results in a large difference in the underlying value, giving an investor the opportunity to speculate and profit if the underlying asset moves in the expected way, or to hedge a portfolio.

With an exchange traded fund, it is much like buying a stock on the exchange in that if you put £100 in, you get £100 worth of exposure.  If you buy futures to get the same exposure to a specific product or area, you go in on a leveraged basis, so you only pay a percentage margin to hold the position.  This can lead to higher volatility if you are placing smaller amounts of money for a much larger exposure.  As such traders really have to look at their cash position, how risk averse they are or how susceptible they are to increased volatility.

When purchasing a futures contract an investor only has to put up a small fraction of the value of the contract as ‘margin’. In other words, the investor can trade a much larger amount of the underlying asset than if he bought it outright. On predicting the market movement correctly, his profits will be multiplied by, say, ten-fold on a 10 per cent deposit.

However, the margin required to hold a futures contract is not a down payment but a form of security bond, so if the market goes against the trader’s position, he may lose some, all, or possibly more than the margin he has put up. But if the market goes with the trader’s position, he makes a profit and he gets his margin back.

Unlike exchange traded funds, which provide investors with exposure to a pool of securities and other assets which can be bought and sold throughout the day, like stocks on a securities exchange through a broker-dealer, derivatives can be used in a number of ways to take advantage of market anomalies.

Using crude oil as an example.  You can pay $1 to get exposure to 1,000 barrels of oil. With current oil price around $90 per barrel, a $1 futures contract gives you exposure to 90,000 barrels – that is huge leverage, not something the average person can do, even with a pot of life savings..

Any stock market can be predictive to some extent in its reaction to events. For example, in the run up to an every important moment – an election or central bank announcement – the market will trend flat and on receiving the news that everyone was widely expecting, it rallies.  Afterwards, when the realisation dawns that everything is not solved, the market responds.

 

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