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How to trade futures?

Trading futures contracts is specifically for the most experienced traders who have specific knowledge from technical analysis.


Long and short positions

Futures are standard, fixed term contracts and they are actively traded on public markets.

A trader who purchases futures takes a long position and the trade who sells futures takes the short position. The buyer has the right and the obligation to purchase the underlying asset at a defined date. The seller has the right and the obligation to deliver the underlying asset at a defined date. From this it follows that the number of open interest long and short positions must match.

Names of futures contracts

The name of a futures contract is taken from the underlying asset, its representation and the date on which final contract settlement will take place.

If the contract will for example be settled in September 2007, its name will include this information and will be called "a September contract".
Abbreviations for the individual months are as follows: January...F, February...G, March...H, April...J, May...K, June...M, July...N, August...Q, September...U, October...V, November...X, December...Z.

Contract size and multiplier

A standard quantity defines the size of a single contract and defined contracts (in terms of size) are used for trading.

No other quantity of the underlying asset can be bought or sold within a single contract. If, for example the contract size on the PX index is 100, then any purchase or sale of a single futures contract on the PX index is bought or sold at 100 shares of this index. The size of the contract serves as the multiplier. This means that movement in the underlying asset is multiplied by the multiplier, which gives us the immediate financial impact of any changes in the underlying asset. E.g. If we own 1 contract for the PX index, and this index changes from 1650 points to 1651 points (one points), with a multiplier of 100, this means ever movement by one point means a profit of CZK 100 in this case.

Requirement on opening a position

When trading futures there is a specific risk that the subject of a long position will not deliver the funds corresponding to the agreed price and the subject in the short position will not deliver the underlying asset.

A margin deposit is made in order to avoid this risk when opening a new position to the margin account, which represents a relatively small portion of the nominal value of the contract. The amount deposited is not provided with any interest. The actual amount of this margin depends on the volatility of the price for futures and the underlying asset.

We must add that the buyer and seller both must deposit this margin. For this reason, when opening a futures contract the buyer does not pay the seller of the contract immediately; rather at contract maturity and the margin is the only initial cost for opening the position for both parties (plus the trading and exchange fees). When opening a position, the buyer does not pay the price for the futures contract and the seller does not receive this amount. The shared cost is the margin requirement.

Changes in prices for futures

The price for a futures contract is nothing more than the term price for the underlying instrument at the maturity date of the futures contract.

In lay terms, the anticipated price of the asset at the maturity date, e.g. September 2007. The price for a term trade therefore depends on the anticipated spot price of the underlying asset, which should "according to the parties on the market" exist on the spot market at the moment the term contract expires.

The price of a futures contract for an underlying asset can be higher or lower than the spot price of the underlying asset depending on the inherent costs (costs for holding the futures or holding the underlying asset) and the expectations of the market in terms of the developments in the price of the underlying asset. The difference in the spot price of the underlying asset and the price of the futures contract is known as the basis.

The basis is negative (contango) when the term price is higher than the spot price, or is positive (backwardance) - when the spot price is higher than the term price. The difference between the spot price and the futures price (basis) increases with longer terms to maturity. As the maturity date approaches, the futures price more closely reflects the spot price and the basis converges towards zero.

The manner in which futures prices are quoted is again standardized. This means that the smallest possible change in a price, i.e. a minimum movement in the price (tick size) is set. The tick size multiplied by the multiplier defines the minimum profit or loss arising from a change in the price equal to the tick size.

Daily settlement of profits and losses (mark to market)

Every day following the closing of the market, the closing house values and settles open positions.

It values all open positions (buy and sell) and determines the profit and loss for the individual prices arising from differences in prices when opening positions and daily price settlement. An entity holding a long position profits from a rise in the price of the futures contract while an entity holding a short position generates a loss from an increase in the price of the futures contract. A loss or profit is credited or deducted to the margin account of every member of the clearinghouse. Every subsequent day the situation repeats and all contracts are settled on a daily basis, profits and losses are totaled and are settled against the price from the previous day as compared to the price in the current day in the event of any changes. This occurs every day until contract maturity.

Example:

We expect a trade with a futures contract for an index with a current value of 1,600 points to occur on 31 December between a buyer (long position) and seller (short position) with maturity on 1 March and a multiplier of 100. Trading in CZK.

DatePriceSellersMutual daily settlement
31.12.1,600 points--
2.1.1,601 points-1 p (- CZK 100)+ 1 p (+ CZK 100)
3.1.1,597 points+ 4 p (+ CZK 400)- 4 p (- CZK 400)
4.1.1,600 points- 3 p (- CZK 300)+ 3 p (+ CZK 300)
----
----
28.2.1,621 points--
1.3.1,622 points+ 1 p (+ CZK 100)-1 p (- CZK 100)

Leverage

Another important feature of futures contracts are leverage, i.e. the entire value of the contract is not necessary when entering a position, only a fraction of the value of the contract is needed (initial margin).

This allows for trading using deposits (between clearinghouses) and a huge volume of trades, increasing market liquidity. Volumes and liquidity greatly exceed the dimensions of the spot market for underlying assets.

Futures maturity

The maturity date of a futures contract is specifically defined by the derivatives market.

This defines the final trading date, the contract maturity date (most times this matches the last trading date) and the date of final contract settlement (most are T+1 following the last trading date). The maturity date usually follows some sort of repeating rule, like the third Friday in the last month of the contract. Futures contracts as a rule have maturities ranging from one to two years.

If multiple futures are issued for a single underlying asset with various maturity dates, the largest trading activity is usually associated with the contract that is closest to the maturity date. The final few days of a contract sees trading decrease and volatility increases. The interest of investors then shifts to the next contract. If a client has no interest in holding a position until maturity, we do not recommend closing the position on the last date before contract maturity.

Closing a position

There are two methods for closing a futures contract.

The first variant is to move to compensate futures before maturity. In practice this means nothing more than selling purchased futures or buying sold futures. The second method is to deliver the underlying asset within the maturity of the futures contract. This is automatically required when a position is held to the maturity date and is finally settled. The first method is the most common way to close a position and is known as offset.

Final settlement

This method of settlement is only used when futures are held to maturity. Again there are two methods used for final settlement, physical settlement or financial settlement.

Physical settlement is the physical delivery of the underlying asset in the maturity term (for a short position) against payment for such delivery at the maturity date (for a long position). The price at which this transaction occurs is the final settlement price. Fio does not allow the physical settlement of futures contracts.

Financial settlement is the use of financial settlement between entities in short and long positions without physical settlement. Due to the daily closing and settlement of profits and losses, financial settlement is limited during financial settlement to settling the difference between the daily price at settlement on the next-to-last day and the price at maturity. This settles the financial differences on the last date.

Futures and dividends

The holders of futures contract do not receive a dividend (for a long position) and no dividend is paid (for a short position).

The price of a futures contract is therefore decreased by the current value of the expected dividend before the expiration of the contract. As a large dividend payment approaches (closer to contract expiration) or if the underlying asset is difficult to borrow, the price of the futures contract can be traded with a discount from the current price of the underlying asset.

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