Posted on Dec 30, 2020 by Staff Writer
A guide for South Africans on how futures contract work
What is a futures contract?
A futures contract is an agreement to buy or sell a specific amount of a commodity or financial instrument at a specific price on a specific date in the future.
To help you understand why businesses and individuals trade futures, let’s examine how futures contracts can be used, the key components that make up a contract, and how much it costs to trade a futures contract.
One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date.
How does a futures contract work?
Locking in a price lessens the risk of being negatively impacted by the price change. Let’s look at how this might work for businesses using the coffee industry as an example.
If the price of coffee beans goes down, it’s good news for coffee shops but bad news for coffee farmers. However, if the price of coffee beans goes up, the tables turn.
With coffee bean futures, both coffee producers and coffee users are able to lock in prices ahead of time. Now let’s look at how this might work for individuals.
Say you’re looking to buy a new home in a year, and you’re afraid interest rates might rise and increase your mortgage payment. You could offset a potential interest rate increase by trading interest rate futures such as Government Bonds.
The second use of futures contracts is to allow traders to speculate on the price movement of commodities, currencies, stock market indices, and other assets. For example, consider the fluctuations in the price of a commodity like gold.
A futures trader can potentially profit by correctly guessing the direction that the price of gold will move. But if the futures trader guesses wrong, he can lose his entire investment and more.
Now that you know how a futures contract is used, let’s look at five key components of a contract.
These are also known as standard contract specifications.
- Trading Hours:
Futures markets are open virtually 24 hours per day, 6 days per week; however, each product has its own unique trading hours.
- Tick Size:
Tick size is the minimum price increment a particular contract can fluctuate. Tick sizes and values vary from contract to contract.
- Contract size:
Each commodity or financial instrument has a standardized contract size that doesn’t change. For example, one contract of crude oil always represents 1,000 barrels. One contract of gold futures represents 100 troy ounces.
- Contract Value:
Another component is contract value, which is also known as notional value. This is the current market value of the commodity represented in a futures contract. To calculate this, multiply the size of the contract by the current price.
Contracts are either financially settled or physically settled. Financially settled futures contracts expire directly into cash at expiration. Physically settled futures contracts expire directly into the physical commodity. This includes products like crude oil. For example, anyone long a contract in crude oil at expiration will receive 1,000 barrels of crude oil.
However, don’t be worried about 1,000 barrels showing up at your front door. South African Futures Exchange (SAFEX) does NOT allow clients to take physical delivery, you are required to close the position before the delivery date, and if you don’t, it’ll be closed for you by your Broker. You can find more information about contract specifications on the JSE website.
Now, to understand how much it costs to trade this contract, let’s look at an example. Suppose a crude oil futures contract is trading at R50.00. At this price, 1,000 barrels of crude oil would cost R50,000.00.
However, a trader doesn’t actually have to come up with this amount. With a futures contract, a trader could control the R50,000.00 worth of crude oil with just a small deposit.
This deposit is called the initial margin requirement, and it refers to the minimum amount of funds a trader needs to enter into this contract.
The initial margin requirement is set by the exchange and subject to change, but in our example, we’ll say that to purchase one crude oil futures contract, the trader had to put up R3,000.00 for margin to control nearly R50,000.00 in oil.
As you can see, futures can allow you to leverage a relatively small amount of capital to control a larger underlying asset. Because of this leverage, small changes in the price of the underlying asset have a much larger impact on the futures contract.
Keep in mind that although leverage allows for strong potential returns, it can also result in significant losses. And if losses are substantial, you will have to add more money to cover losses.
Now you know how futures contracts can be used, what the contract specifications are, and how much a futures contract costs. If you’re interested in investing in futures contracts, it’s important that you expand your investing education before you make investments.
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