The Basics of Investing and Trading

What are futures?
Futures are legally binding contracts that give the buyer the right and the obligation to buy a pre-determined asset at a pre-determined price at a pre-determined time. Conversely, the seller has the right and the obligation to deliver that pre-determined asset at that pre-determined price at that pre-determined time.The underlying assets can be stocks, bonds, baskets of stocks, commodities etc.

How are futures traded?
Like stocks, futures are traded on exchanges. The exchange regulates the details of the futures contracts and their trade. The exchange also acts as the counterparty in the case of the buyer as well as the seller of the futures contract, i.e. buyers buy futures contracts from the exchange and sellers sell these contracts to the exchange.This virtually eliminates the risk of default as far as the buyers and sellers are concerned.

Modalities
Futures prices are market determined and there is usually no fee needed to take a position (unlike options). Futures positions can be closed by either delivering the underlying asset using something called the delivery option or by paying (or receiving) the loss (or gain) on the contract in a process called cash settlement. Futures can also be rolled over to a later date as long as all margin requirements are met.
Futures give investors leverage as they expose investors to large possible changes in the value of their position with small amounts of initial capital. Leverage serves to multiply gains as well as losses.

For example, in order to gain exposure to the movement in price of 1000 shares of PQR Corp, trading at $10 per share, an investor could spend $10,000 and buy 1000 shares. A 5% increase in the share price of PQR would give him a profit of $500, i.e. 5% of his initial investment. This is the traditional way of investing.However, if the same investor were to enter into a futures contract, he would only have to put up the initial margin which is say, 10% of the value of the contract, i.e. $1000. The same 5% increase in price of the underlying shares would give him the same profit, i.e. $500. However, this is 50% of his initial investment. Unfortunately, this is true even for losses. A 5% fall in the price of the underlying shares would also cause a loss of 5% to the stock investor by a loss of 50% to the futures investor.

Terminology

Long Position: When an investor enters into a contract to buy a certain asset at a certain market determined price, he is said to take the long position in that contract.

Short Position: When an investor enters into a contract to sell a certain asset at a certain price, he is said to take the short position in that contract.

Marking to Market (MTM): The process by which the value of holding a given futures contract at that particular moment of time is determined. This value of a contract is the money that were to be gained or lost if the contract were to be settled at that moment. This is usually done on a daily basis by the exchange. The gains or losses from marking to market are immediately credited (or deducted) from the investors’ accounts.
For example, if an investor were holding a long position a futures contract on ABC Stock at $ 714 and the market price of ABC stock were $720, she would gain $6 in the process of marking to market. This amount would immediately be credit to his/her account.

Initial Margin: This is the amount of money that investors have to deposit as a performance guarantee in order to open a futures position. This amount is determined by the exchange and is typically about 10-15% of the value of the futures contract.

Maintenance Margin: This is the minimum amount of money, as a percentage of the contract’s value, which investors have to put up in their account as a performance guarantee. If investors lose money during the process of marking to market and their account margin falls below the maintenance margin, a margin call is triggered and they will have to deposit more money.

Expiration: The day the contract expires and the asset has the delivered is called the expiration date of that contract.

How individual investors can invest in futures
Investors can open futures positions through a broker. The broker would then give access to futures traded on an exchange.

Advantages

1. Futures give investors leverage and can thus be used to achieve large gains with small amount of capital.
2. The exchange is the counterparty to all futures transactions and thus, there is virtually no credit risk involved.
3. Futures can be used for speculation as well as hedging.

Disadvantages

1. The leverage that futures contracts give investors in also their biggest disadvantage. Investors can potentially lose more money than they had initially invested.
2. The mark to market feature of futures can potentially impose severe cash-flow pressure on investors.

Risks

1. This biggest risk of entering futures contracts is the risk arising from large amounts of leverage. Small fluctuations in the price of the underlying assets could result in large losses.
2. If investors are not able to meet margin calls, their position is liquidated. One way to minimize this risk is to over-collateralize the futures position.