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How does Futures pricing work? - Outside View

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How does Futures pricing work?
Jul 22, 2010

As I discussed in the previous week, a futures contract is an agreement to buy or sell an asset on a particular date in the future. Futures are exchange traded, highly regulated, and usually liquid. They offer individuals an easy way to invest in currencies, commodities, stock indices, and individual stocks. First, well discuss some of the mechanics of futures contracts. Then well follow with a discussion on how futures are priced.

Futures contracts are not actually bought and sold. Instead, they are entered into. An investor enters into a contract to buy Gold at a certain price, rather than buying the contract itself. Later on, the investor can enter into an opposing position, i.e. a contract to sell Gold and this will close out his position. Because contracts are not bought and sold, no cash is exchanged between parties up front. In fact, an investor wont even be aware of the counterparty to his trade. Instead, he settles his position with the exchange.

The mechanics of trading futures

Lets use a crude oil future as an example to illustrate the mechanics of trading futures. Assume that on 1st July the investor goes long one July crude oil contract at a price of Rs 3,500 on the MCX. Contract specifications are as follows:

Expiry: 19th July

Quotation: Rs. per Barrel

Trading Unit: 100 Barrels

Initial Margin: 5%When I enter into the contract, the total value of the position is Rs. 3,50,000 (This is the price multiplied by number of barrels multiplied by number of contracts). I have to put up the initial margin which is 5% of the total contract value, i.e. Rs. 17,500. This money is held by the exchange as collateral in case the position loses money. At the end of the trading day, the exchange will mark to market the position. This means that they will pay me if the contract has increased in the value, or I will pay them if it has decreased in the value. The next day, I will again keep a margin deposited with the exchange to cover potential future losses. The profit/loss from this position will be the difference between Rs. 3,500 and the final spot price on 19th July multiplied by 100 barrels. Because I have gone long, if the spot price is higher (lower) than Rs. 3,500, I will make a profit (loss).

Pricing relative to underlying assets

Lets take a look at how futures are priced relative to their underlying assets. Futures (and all derivatives) are priced on the assumption that there is no arbitrage, or risk free profit. This means that whether you purchase the underlying asset, or a long a futures contract, your return should be the same. For the purposes of trading to speculate on currency, commodity, or stock movements, this is all one needs to know. I will not go into the mathematical relationships that define futures pricing, those who are interested should consult a textbook. In general, futures prices track spot prices very closely. The prices become equal at maturity of the futures contract. The no arbitrage conditions assure the investor that the return from holding the underlying asset or the future will be the same.

Futures contracts can also be understood as an expected value of the spot price. Depending on the market condition, future prices can be either higher or lower than spot prices. This is known as the term structure of prices. If futures prices are higher (lower), the market is said to be in contango (backwardation). This can be used as an indication of where the market expects prices to move in the future. The term structure reflects current supply and demand versus expected future supply and demand.

One of the primary advantages of futures is leverage. Going back to our crude oil future example, we can see that to control a position that was worth Rs 3,50,000, we needed only an initial deposit of Rs. 17,500 (which is 5% of the value of the contract). Leverage can magnify your returns as well as your losses, so risk management becomes increasingly important in trading futures. If crude oil rises 5%, I will make a 100% return on equity, and if crude oil falls 5%, I will have lost everything! For this reason, futures are extremely useful for short term trading, when one is looking for a small change in the underlying asset to make a profit. If I wanted to invest in oil longer term, Id probably keep aside more than the minimum 5% required to fund the position simply because oil is volatile and can certainly move more than 5% over a longer timeframe. Alternatively, I could buy an oil ETF but then I would not get the leverage that futures provide.

If I wanted to invest in company XYZ, what would be the difference between buying the stock versus going long a futures contract? Buying the stock would mean I have to pay the full amount, I would receive dividends, and my position would be perpetual until I sold the stock. Going long a futures contract would mean I put up only a small percentage of the total position value, I would not receive any dividends (as only actual stockholders receive them), and my position has an expiry date. For the shorter term, futures are advantageous due to the leverage allowed. In the longer term, futures are disadvantageous due to higher transaction costs (needed to enter into new contracts when existing ones expire) and lack of dividends. For commodities and currencies, trading futures is much better than trading the underlying as it is very difficult for retail investors to physically hold and trade commodities and currencies. Trading the future allows an investor the benefit from price movements without dealing with the underlying product.

Now that weve had a look at how futures work, the next step is to actually start trading them! Next week, I will explain some basics of trading futures and some specific strategies that can be applied. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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2 Responses to "How does Futures pricing work?"

Rajani Mohan

Jul 31, 2010

good to know the basic pleaqse up date with the current position and tradings etc. and working through stock brocker or to do on line.



Jul 28, 2010

The first series had a very good example, this oil example is not clear and I had to read it twice to understand. Regardless this is informative.

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