Futures 101 – 8 Frequently Asked Questions About Futures
1. What Is A Futures Contract?
A futures contract is a type of derivative or financial contract in which two parties agree to make a certain transaction on a specified future date at a specified current price. A futures contract does not give you ownership of a commodity or product. You are purely entering into a contract to purchase or sell the underlying products on a future date at a certain price specified in the contract.
2. Where Are Futures Contracts Traded?
Futures contract are traded in a futures exchange where buying and selling of the underlying products specified in the futures contract takes place. Futures trading is facilitated through a regulated exchange, established to act as central platform between the buys and sells of all types of traders from business entities to the individual traders. By having this mechanism in place, transactions are regulated of which futures contracts are standardized according to the contract specification of each products. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
3. What Happens When I Decide To Buy A Futures
There can be two scenarios derived from buying a futures contract. The first scenario involves the physical delivery of a particular commodity. The second can be used as a financial instrument in which to call for an eventual cash settlement. Both involve transacting the contract at a particular price on a specified future date.
Example: Buying (Long) a Crude Palm Oil futures contract at RM2,470 for January 2011 simply creates a contract between you (the buyer) and the seller, whom you need not know as the exchange act as a middle man (a buyer to the seller and a seller to the buyer) and will guarantee all the trades done. Come January 2011, you will either do one of the following:
(a) Accept physical delivery of 25 metric tons of Crude Palm Oil priced at RM2,470 per metric ton in any one of the delivery date between 1st – 20th January 2011 and pay the full value of the contract to the seller (RM2,470 x 25 metric tons = RM61,750), or
(b) Sell (Short) the contract prior to delivery date at the going market price. The difference between the buying price and selling price translates to either profit or loss.
4. What Are The Types Of Futures Contracts I Can Trade?
There are a few major groups available for futures trading such as agricultural products (e.g. crude palm oil, soy bean), energy (e.g. crude oil), metals (e.g. gold, silver), live stocks, financial instruments, and stock indices.
5. Who Regulates The Futures Market?
In Malaysia, futures and options traded on the Bursa Malaysia Derivatives exchange (BMD) are regulated by Securities Commissions Malaysia (“SC”). Futures brokerage firms incorporated in Malaysia are required to obtain a license from SC and to become a Trading Participant of BMD as well as a Clearing Participant of Bursa Malaysia Derivatives Clearing Sdn Bhd (“BMDC”) before getting involved in futures broking activities.
All futures and options contracts traded on other exchanges are regulated by the respective futures trading commissions in the countries where they are set up. Only futures and options contracts on licensed exchanges can be legally traded throughout the world.
The term “Specified Exchanges” refers to futures exchanges outside of Malaysia specified under Futures Industry Specified Exchanges Ordinance (FISEO) of the Capital Markets Services Act 2007 and read together with Appendix C of the Business Rules of Bursa Malaysia Derivatives. Only those derivatives products listed in the Specified Exchanges and are approved by SC will be allowed to be traded in Malaysia.
6. What Are The Common Purposes And Benefits Of Trading Futures Market?
(i) For Producers Seeking Hedging and Risk Management Instrument
Hedgers trade futures market as a method of keeping price risk in check against unfavourable price movements in the physical market.
(ii) For Speculators Seeking to Profit from Price Fluctuation
Speculative investors use futures contract to speculate and seek to profit from a change in the price; they buy when they anticipate rising prices and sell when they anticipate declining prices. The appeal of trading futures market is that it gives trader the leverage to control the value of a contract worth a lot of money with very little capital. Typically, a futures contract can be bought or sold with a margin of 2% to 20% of the value of the contract size, which translate to high leverage.
Example: If Live Cattle futures requires a minimum margin of $800 to trade a single contract, and if a contract represents 40,000lbs at the current market price of $0.75 per pound, you would be controlling $30,000 worth for a leverage of over 37.5:1.
7. Is There Any Risk Involved?
It is important to note and remember that futures trading are speculative in nature and involves substantial risk of loss – just as the market can work in favour of the trader; it can also work against the trader at the very same ratio.
8. How Do I Make A Return Of Investment From Trading Futures?
If the price moves in the direction you anticipated, high leverage can produce large profits in relation to your initial margin.
Example: Assume that in anticipation of rising stock prices, John buys an August contract of FBM Kuala Lumpur Composite Index Futures (FKLI) at a time when the index is trading at 1,000 with assumed margin requirement of RM2,500 per contract. The value of the futures contract is calculated as RM50 x 1,000 which is the current index price. A 1-point increase in the index represents a RM50 gain. Hence, a 25-point increase in the index (from 1,000 to 1,025) would represent a gain of RM1,250. That’s a 50% gain as a result of only a 2.5% change in the stock index!
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