Futures - SGX SIP Online Education Module
Derivatives
A derivative is a type of financial contract whose value is derived from other underlying assets like
- Financials (e.g. an equity index, stocks, currency)
- Commodities (e.g., gold, oil, iron ore, rubber)
Common types of derivates includes futures, options, forwards and warrants. Derivates can be used for speculative or hedging purposes.
Most derivatives are leveraged products, you get a larger exposure in the underlying asset for a relatively small cost. Leverage works in both ways; while gains are multiplied, the potential loss is also magnified.
What are Futures?
Futures contracts give investors the obligation to buy or sell the underlying asset in a specified quantity at a specified price (the future price or delivery price), on a specified future date (the delivery date or settlement date).
Futures are subject to margin requirements and have partial settlements of emerging gains/losses through daily mark-to-market processes.
How do they work?
- An investor who expects the price of the underlying assets to appreciate adopts a long position by agreeing to buy and receive delivery of the underlying at the delivery price.
- Similarly, if he expects the price to fall, he adopts a short position by agreeing to sell and deliver the underlying at the delivery price.
Types of Futures
- Financial futures are futures contracts based on financial instruments, such as currencies, equities, equity indices, interest rates.
- Commodity futures are contracts based on physical commodities such as gold, crude oil, etc.
Margins
- Futures are traded on margin
- The initial cash outlay is called initial margin and is a fraction of the full value of the contract
- The broker may add additional margin requirement for specific clients, products or markets based on risk analysis
- The ability to trade at a fraction of the value of the contract creates teh leverage effect of futures trading
Mark-to-Market
- It’s the daily process of revaluing outstanding positions of the daily settlement price. The resulting profit and loss are added to or deducted from the margin account.
- The broker issues a margin call when the initial margin is eroded by losses, and falls below the minimum margin requirement (the maintenance margin)
- The additional amount required to restore the account to the initial margin is called variation margin.
- Losses can exceed initial margin deposited. If the margin calls are not met, the broker has the right to liquidate the holdings in the futures to raise the necessary amount.
Settlement Methods
Futures contracts can be settled in two ways:
- Physical delivery: physical delivery of the underlying assets by the seller to the specified location on the specified delivery date
- Cash settlement where the parties settle by paying or receiving cash from the loss or gain related to the contract The settlement method is specified in the contract.
Key Features of Exchange Traded Futures
- Central clearing house acts as a counterpart to fulfil the contract terms
- Clarity of standardised features
- Availability of an avenue for price discovery and thus trading
Key differences between options and futures
- Definition:
- Futures: A Futures contract is a binding agreement, for buying and selling of an underlying asset at a predetermined price at a future specified date
- Options: are the contract in which the investor gets the right to buy or sell the underlying asset at a predetermined exercise price, on or before a certain date, however the investor is not obligated to do so
- Obligation of Buyer:
- Futures: Yes, to execute the contract
- Options: No, there is no obligation
- Execution of Contract:
- Futures: On the agreed date of a futures exchange
- Options:
- European style: A contract that may only be exercised on expiration;
- American style: A contract that may be exercised on any trading day on or before expiry date
- Risk:
- Futures: High
- Options: Loss limited to invested amount for long position but higher when writing/short selling options
- Advance payment:
- Futures: No advance payment, only requires deposit of margins
- Options: Paid in the form of premiums that indicate the probability that the option will expire In-The-Money
- Degree of Profit/Loss:
- Futures: Unlimited - both profits and losses
- Options: Unlimited profit and limited loss (Option buyer)