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Focus on Futures: Fundamentals

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As we have already seen earlier in this module, futures contracts are contracts to buy or sell a specific underlying instrument at a specific time in the future, for a specific price.

  • Buying (going long) a future commits you to buying the underlying at a future date.    
  • Selling (shorting) a future commits you to selling the underlying at a future date.

All futures are exchange-traded contracts and they are standardised in terms of the delivery date, the amount of the 'underlying' they relate to, and the contract terms. They are also contracts with a limited lifespan - i.e. they expire after a certain date.

Although futures contracts, if held till "delivery", lead to fulfilment of their commitments, generally speaking, very few contracts are taken to delivery. Instead, holders of futures positions will normally "close out" by selling the contract - thus avoiding the prospect of having to make/take delivery of the underlying.

Margin and leverage

When clients wish to buy or sell a futures contract they instruct a broker, who will be a member of the exchange where the futures contract is traded. The broker will then instruct a marketmaker to execute the order on their behalf.

Unlike trading underlying markets, when you buy a futures contract, it doesn’t involve actually paying for the full market exposure of the contract you have bought. Rather, the position is established at that price level. Profits or losses due to any subsequent price changes are paid out or received on a day to day basis.

A small percentage of the overall contract exposure is deposited as "margin" when a position is opened - so-called initial margin - and refunded on closing. The size of this margin bears a relationship to the likely price movements as well as the size of the position taken.

As long as the position is open this margin is marked-to-market on a daily basis. Marking-to-market simply means that the size of the margin is adjusted to take account of the end-of-day value of the open position. If the position has generated a profit this is credited to the contract holder's account and, indeed, they may be able to withdraw margin.

If the position has generated a loss then the customer must deposit additional funds to restore the margin to its initial level. This payment is called variation margin.

Apart from the small transaction cost per contract bought or sold, the initial and variation margin are all that an investor has to put up to control a much larger amount. For this reason, futures contracts, like other derivatives contracts, provide leverage.

     

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