A Primer on Futures Contracts – II
In the last post, we looked at the fundamentals of futures contracts. This week, we will conclude by looking at a few more interesting aspects of futures contracts.
Variations between Stocks and Futures
In the stock market, the holder of a security may witness many days of paper gains and paper losses during their holding period. In other words, the gain or loss on a stock that an investor incurs is decided on the day that they actually sell their shares. However, in the futures market, the profit and loss of a contract is computed everyday.
Continuing the example from the previous post (corn futures contract), if the price of the corn futures contract increases to 660 cents per bushel (from 640 cents per bushel) a week or two after the contract was finalized, then the fuel ethanol manufacturer would profit because he is required to pay 20 cents less per bushel than what the market would pay in the future. The farmer is evidently at a loss since he will have to sell for 20 cents less per bushel than what the market is currently willing to pay in the future.
These monetary changes are computed and both counterparties to the futures contract will see the impact in their accounts. The fuel ethanol manufacturer (the gaining party) will see a credit in his account and the farmer (the losing party) will notice a debit in his account. Such debits and credits happen on every trading day to reflect the changing fortunes.
Closing the Futures Contract
The actual corn (or any commodity for that matter) is traded on the cash market. Let us assume that the price of corn at the time of settlement, when the party wants to close their position, is 680 cents per bushel. The fuel ethanol manufacturer will purchase the corn in the cash market and they will pay the price of corn as sought by the cash market, i.e., 680 cents per bushel. Nonetheless, the profit that the fuel ethanol manufacturer (the buyer) made from their futures contract (originally set at 640 cents per bushel – please see the last post) will offset the higher market price that they would pay.
Similarly, the farmer will technically sell at a high cash market price of 680 cents per bushel but the loss they incurred from the futures contract (due to daily adjustments) will ensure that they end up in the red.
Pricing of Futures Contracts
Futures contract pricing involves a minimum movement amount, known as tick, to be met. These exchange-set ticks are significant to a futures investor as the minimum price movement can impact their bottomline. For example, for a $10,000 futures contract of commodity ‘XYZ’, if the tick is $0.01, then the lowest price change is $100. This minimum amount for that specific futures contract is called as its tick value.
Futures and Leverage
As with the forex market, leverage plays a big part in the futures market, magnifying both gains and losses. At the time of opening a futures contract, an initial deposit of money called initial margin is made into the account. This money is the capital from which daily losses are deducted and to which daily profits are added. This initial margin is usually a small percentage of the actual futures contract, thereby enabling a trader to enter into a contract with barely-available resources when compared to the value of the futures contract.
As would be evident, such relatively small deposits for entry makes futures an enticing proposition. However, please remember that there is seldom gain without pain; do your due diligence before considering them for speculation purposes (hedgers have a valid reason for using them).
How has your experience been with futures contracts? Do you have any tips or stories to share with fellow readers?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.