What are futures and how do they work?

Trading a futures contract is like buying or selling a perfect slice of the index upon which it is based, immediately, with lower transaction costs relative to buying the stocks themselves.

What is a futures contract?

A futures contract is an agreement under which one party (the “buyer”) agrees to buy a certain asset or instrument at some point in the future from another party (the “seller”) at a pre-determined price that is agreed upon today.

In financial markets, futures contracts are useful because they allow investors to take a view on price movements for certain financial instruments (such as an equity index) with only a relatively small initial outlay (“initial margin”) and to close out their position simply by effecting an offsetting trade.

Future contracts are available globally across many equity, commodity and fixed income markets. As the value of a futures contract is derived from other instruments (eg the underlying index) futures contracts are called Derivatives.

The “SPI” Index

As might be expected, there are futures contracts that cover the Australian S&P/ASX 200 Index.

In this case, an ASX SPI 200 futures contract gives the owner the right to receive $25 in cash for each index point that the index is trading at, at a specified future point (expiration date) in time.  So if the S&P/ASX 200 Index was trading at 5000 points at expiry, one SPI futures contract would be worth $125,000.

As should be evident, the price at which a futures contract trades today will be based on market expectations as to where the share market might be trading when the contract expires.  In general, if the S&P/ASX 200 Index rises by 1%, the price of near-dated SPI futures contracts (say, due to expire in less than a month or so) will also tend to rise by around 1%.

Note, moreover, to buy one futures contract, the “initial margin” is currently $8500, meaning an investor only needs to outlay 6.5% of the total value of contract exposure obtained.

How are futures used?

Futures may be bought and sold – for the amount of exposure they provide they can be traded more quickly, more accurately and at a lower cost compared to trading a slice of the index with actual underlying stocks. In the below, we provide an example of how futures can be used in practice.

Risk Management Overlay

Let’s assume a portfolio manager has an equity portfolio with stock value of $6,000,000 and some cash.  Volatility in the market is high and rising.  In these market conditions, let’s assume the portfolio manager wants to get completely out of the market, or at least to hedge his exposure.

One obvious option is to simply sell stocks to reduce equity exposure.  But the downside of this strategy is that it can involve significant brokerage costs.  Selling long-held stocks may also give rise to taxable capital gains that will need to be paid.  What’s more, the manager will then face significant trading costs should he decide to buy back (perhaps the very same) stocks and get back into the market at a later time.

An alternate strategy is to hedge market exposure by selling SPI futures contracts.

How? Let’s assume the S&P/ASX 200 Index, and the SPI futures price is around 6,000 points.  The current value of a SPI contract, therefore, is around $150,000 (6,000 x $25).

As a result, the manager could obtain a short futures position equal to his $6m share portfolio through selling 40 SPI contracts (40 x $150,000 = $6m). His initial margin or outlay would be only $340,000 and transaction costs would be $3 per contract, or $120.

Now let’s see what happens if the share market falls 15%.

A 15% fall in the market (to 5100 points) could reduce the market value of this share portfolio by 15%, or $900,000.

But assuming the futures contact price had also fallen broadly in line with the market, the manager would generate an offsetting gain from his short position in the futures market.

Indeed, if the futures price had also fallen 15% to 5100, it would now only take $5.1m (40 x $25 x 5100) to close out or buy back his $6m short position – leaving a net profit of $900,000.

As this profit on the futures position offsets the paper loss made on the pre-existing portfolio of shares, the overall portfolio acts as if it were fully hedged or in cash.  This gain is now able to be put to work, as and when the manager chooses, through buying more stocks in the market.

Of course, if the market rises instead, the manager would need to sell some of his shares – which are now worth more – to pay-off off the loss on the futures short position.  Either way, the overall portfolio is left largely immune to market direction over the time in which the short futures position is in place.

The above example is not dissimilar to the way that futures are used by the BetaShares Managed Risk Series.

Find out more about the Funds within the series by visiting the relevant Fund page: